Cases and rulings on the marital deduction, and miscellaneous estate and trust issues.

Parts I and II of this article, published in September and October 1991, discussed recent court decisions and IRS rulings on insurance, powers of appointment, retained interests, valuation, gift tax, administration expenses and claims, and disclaimers. This third installment covers the marital deduction, and miscellaneous estate and trust issues. The fourth installment, to be published in December, will cover generation skipping, the charitable deduction and income taxation of trusts and estates.

Marital Deduction

Recent developments relating to the marital deduction included the following.

* Various marital clauses were found to be within the ERTA's transition rule. * State law notwithstanding, a terminable interest was created by requiring a spouse to survive estate distribution. * An estate settlement agreement destroyed the marital deduction. * The executors' ability to divert assets by not electing QTIP status destroyed the marital deduction. * The executor's failure to elect QTIP status, on Form 706, Schedule M, destroyed the marital deduction. * The surviving spouse's right to occupy and use a residence qualified as QTIP. * A QTIP trust was not required to pay undistributed income to the surviving spouse's estate. * A testamentary trust with income to the surviving spouse for life and remainder to charity qualified as a QTIP trust. * A postmortem family agreement to shuffle assets destroyed the marital deduction. * A testator's guarantee of third-party loans to his children jeopardized the marital deduction.

* Various marital clauses deemed within transition rule In Levitt,(101) the decendent's marital bequest was described as an amount equal to "the maximum marital deduction allowable for federal estate tax purposes on my death, reduced by the final federal estate tax values of all other property . . ." passing to his spouse. A second clause required the marital bequest to be reduced by an amount, if any, "needed to increase my taxable estate to the largest amount that will not result in a federal estate tax being imposed by reason of my death, after allowing for the unified credit...." The revocable trust agreement containing the above language was executed in June 1975, and amended in March 1978. The decedent died in 1985, making no other amendments or modifications to the trust agreement.

The Tax Court concluded that the above language qualified for the unlimited marital deduction under the transition rule provided by Section 403(e)(3) of the Economic Recovery Tax Act of 1981 (ERTA).

Critique: ERTA Section 403(e)(3) states that if a decedent dies after Dec. 31, 1981, leaving a will providing for the maximum marital deduction allowable by law, such a provision will be interpreted under the law existing before the ERTA, if the instrument was executed before the date which is 30 days after the ERTA's enactment, and no amendment was made after such date specifically referring to the formula marital deduction.

In Levitt, the IRS asserted that the marital bequest was a maximum marital formula expressly within the meaning of the transition rule. The Tax Court, reversing its previous decision in Blair,(102) held for the taxpayer. The court noted that the first half of the marital bequest clause was clearly a maximum marital formula under ERTA Section 403(e), as it defined the surviving spouse's interest expressly in terms of the maximum amount of property qualifying for the marital deduction. However, the formula was significantly modified by the subsequent provision reducing the marital bequest by any unified credit equivalent available at death. The court concluded that the decedent's intent was clearly to minimize federal estate taxes, and not to limit the amount of property passing to the surviving spouse. The Tax Court issued similar decisions in Higgins(103) and Kendall,(104) both presenting facts virtually identical to those in Levitt.

* Requirement that surviving spouse survive distribution creates terminable interest In Heim,(105) the decedent's will left his entire estate to his surviving spouse. However, if the spouse failed to survive distribution of the estate assets, the surviving spouse's children by a prior marriage were designated as alternative legatees. Notwithstanding a California statute expressly limiting the period of distribution to six months (with a view toward preserving the federal marital deduction), the Ninth Circuit held that the marital bequest was terminable and no deduction was allowable.

Critique: Sec. 2056(b)(1) expressly states that certain terminable interests will not qualify for the marital deduction. A terminable interest is one that will terminate if the occurrence or nonoccurrence of an event can cause the property to pass from the decedent to a third party. However, Sec. 2056(b)(3) permits a contingency for the survivor's subsequent death within six months if the death does not in fact occur. All parties agreed that, absent the California statute, the decedent's marital bequest was terminable since the period of distribution could exceed six months and the surviving spouse could die before final distribution.

The taxpayer asserted deductibility based on the California statute, which was expressly designed to bring terminable interests, such as the one found in the decedent's will, within the Sec. 2056(b)(3) exception. The California statute stated that if "an instrument that makes a marital deduction gift includes a condition that the transferor's spouse survive the transferor by a period that exceeds or may exceed six months ... the condition shall be limited to six months as applied to the marital deduction gift." The Ninth Circuit held that the California statute would have saved the marital deduction in Heim had it been evident in the will that the decedent intended that the bequest qualify for the marital deduction. Since no evidence to that effect was found in the will, the deduction was disallowed.

The decision in Heim is extraordinarily restrictive in its interpretation of Sec. 2056 and the California statute. In effect, the Ninth Circuit concluded that the California savings statute applied only to gifts that were intended to qualify for the marital deduction. Further, since the decedent's will did not mention the marital deduction, nor was there evidence that the marital deduction was discussed with the decedent by either his spouse or attorney, there was no evidence that a marital deduction was sought. This result has a distinct element of the absurd. Obviously, the decedent intended primarily to provide for his spouse and this intent was evidenced by his bequest of 100% of his estate to her. Further, if a marital bequest is couched as 100% of an individual's estate, rather than as a formula, there should be no legal or practical requirement to express in the document that the decedent intended the bequest to qualify for the marital deduction. Finally, since the decedent had no issue of his own, it is not unreasonable to assume that his attorney did not go into great particulars concerning the marital deduction thinking that the entire amount would qualify for that deduction.

Planning hints: The result in Heim is unfortunate for two reasons. First, the loss of deduction must be attributed primarily to inadequate drafting of the marital bequest clause. For the past several decades, it has been recognized that the marital deduction can be lost if its ultimate passage is contingent on the surviving spouse living past the period of distribution. This language should not have been included in the will, notwithstanding the savings statute passed by California. Second, despite the drafting error, the authors believe that the Ninth Circuit used tunnel vision when interpreting the application of the California statute to the facts in Heim.

* Estate settlement agreement results in loss of marital deduction In Schroeder,(106) shortly before his death, the decedent transferred marketable securities to a joint stock account, naming his wife as joint tenant. In addition, he amended his will to provide for the distribution of his probate estate to a trust, with income payable to his surviving spouse for her life and the remainder passing to his children. The decedent's two children, by a prior marriage, were unaware of the joint stock account.

At death, considerable tension arose between the surviving spouse and her stepchildren. In order to alleviate this tension, the surviving spouse entered into a formal agreement under which the joint stock account was conveyed to a trust with income payable one quarter to her for life and three quarters to the children. On the surviving spouse's death, the trust property would pass to the children. In addition, the surviving spouse elected a statutory share in the probate estate, and conveyed this share to the trust established under the agreement. The Tenth Circuit held that the marital deduction was not available.

Critique: The decedent's federal estate tax return claimed a marital deduction in an amount equal to the joint stock account and the statutory share. It asserted that the former passed by operation of survivorship law to the surviving spouse and that the latter was deemed to have passed under the statutory election. Neither interest passed under the will.

The IRS asserted that neither interest was ultimately retained by the surviving spouse because of the settlement agreement and, consequently, did not qualify for the marital deduction. This argument was based on Regs. Sec. 20.205(e)-2(d), dealing with settlements under a will contest, as well as general policy considerations.

The Tenth Circuit held that Regs. Sec. 20.2056(e)-2(d) did not apply, since it is expressly limited to bona fide contests of property interests passing under a will. However, it did hold for the IRS on general policy considerations. The court noted that the underlying structure of the marital deduction is a two-tiered mechanism by which property not subject to tax in the first spouse's estate is taxable in the estate of the surviving spouse. In Schroeder, the settlement agreement could result in an abrogation of this taxing scheme. The surviving spouse, by virtue of the settlement agreement, disposed of her interest in both the joint stock account and the statutory share. As such, that property passed to a trust that did not qualify for a marital deduction. Further, the surviving spouse's interest in that trust would not cause the property to be includible in her estate at death. Thus, if a marital deduction was allowed with respect to that property, its value would not be includible in either estate.

Planning hints: The Tenth Circuit's holding is reasonable and equitable. Unfortunately, it appears that the advisers to the decedent's estate inadequately addressed the federal estate tax implications of the settlement agreement. Of course, it is conceivable that the family discord arising out of the decedent's dispositive scheme was so great that tax considerations were irrelevant to achieving resolution. Notwithstanding, the discord giving rise to the agreement obviously cost the estate and its heirs significant estate taxes.

* Marital deduction lost when executors could divest assets from QTIP In IRS Letter Ruling (TAM) 9104003,(107) the decedent's will provided for a pecuniary marital trust. Article IV(c) of the will expressed the decedent's intention that the bequest qualify for the marital deduction to the extent that the executor elected qualified terminable interest property (QTIP) status. Article IV(f) authorized the executor to make or not make the QTIP election based on his assessment of the most advantageous course. To the extent that no QTIP election was made with respect to the marital trust, the assets would be distributed to a family trust containing a sprinkle and spray provision with respect to trust income. The IRS concluded that the marital deduction was not available to the estate.

Critique: Sec. 2056(c) provides that no marital deduction is available if it is impossible at the time of the decedent's death to ascertain the particular person or persons to whom an interest in property may pass. In effect, Sec. 2056 allows the marital deduction only for property passing from the decedent to the surviving spouse at the date of death.

In Letter Ruling (TAM) 9104003, the IRS correctly pointed out that the surviving spouse's interest in the marital trust was conditioned on a positive action to be taken by the executor of the estate. The surviving spouse's interest in the QTIP trust, and the composition of the QTIP trust, was wholly dependent on the extent of the QTIP election made on the decedent's federal estate tax return. Consequently, the interest was not deemed to have passed from the decedent within the meaning of Sec. 2056, irrespective of whether or not the QTIP election was made.

The IRS's position was upheld under similar facts in Clayton.(107a)

Planning hints: The conclusion in this ruling should have been no surprise to the decedent's advisers. The IRS's position is well supported and other private letter rulings have reached similar conclusions over the past several years. The loss of the marital deduction in this instance should be attributed solely to inadequate draftsmanship.

* Failure to elect QTIP causes loss of marital deduction In IRS Letter Ruling 9037003,(108) the decedent's will bequeathed property to a trust for the benefit of the surviving spouse. Under the terms of the trust, the surviving spouse was to receive income annually, with the remainder passing to the decedent's issue on her death.

On the federal estate tax return, the executor failed to check the box on Form 706, Schedule M indicating an intent to elect QTIP status and listed the trust under Part I of Schedule M, entitled "Property Interests which are not subject to a QTIP." Part II, dealing with QTIP bequests, was left blank. The IRS concluded that a valid QTIP election had not been made and no marital deduction was available.

Critique: The IRS noted that both Schedule M and the related instructions are clear in detailing the requirements of a QTIP election. It also cited Higgins(109) for the proposition that an estate must make "[a]n unequivocal manifestation of an affirmative intent to make the election of QTIP treatment on the estate tax return." This need for an unequivocal manifestation of intent is derived from the fact that the QTIP election, in addition to conferring marital deduction benefits on the estate, also carries significant burdens. The primary burden is that the surviving spouse is deemed to have agreed to include the QTIP property in his federal estate tax return.

The IRS found no such expression of intent for three reasons. First, the required election box was not checked. Second, the property was incorrectly reflected on Part I of Schedule M, which is clearly intended for non-QTIP property. Third, the trust description contained in Schedule M made no mention of QTIP status or an intent to elect QTIP. A similar result occurred in Spohn,(110) which involved virtually identical facts, except that the executor actually checked the "No" box with respect to the QTIP election.

Planning hints: The results in this ruling and Spohn resulted from the careless preparation of the decedents' federal estate tax returns. In both instances, the IRS denied the marital deduction with resulting tax cost to the estates. The facts in each case would seem to indicate that the return prepares and executors were unaware that the trusts failed to meet the marital deduction requirements absent a QTIP election. Few elections in the federal tax law can have as significant an effect as the QTIP election. A failure to accurately execute that election can result in severe loss to the estate and potential surcharge against the executor. Note: On a showing of good cause, taxpayers may request retroactive relief for misfiling of a QTIP election under Temp. Regs. Sec. 301.9100-1T.

* A right to occupy and use a residence qualifies as QTIP In IRS Letter Ruling 9046031,(111) the decedent bequeathed his personal residence to a trust for the benefit of his surviving spouse. The trust instrument provided that the spouse had the right to occupy the residence for her lifetime and, should she cease occupancy, she would be entitled to receive all rental income derived from that residence. The trust instrument also directed that the surviving spouse personally incur the day-to-day costs of regular maintenance and temporary improvements. Permanent improvements were expressly considered an obligation of the trust. The IRS concluded that such an interest in a residence qualifies for QTIP status.

Critique: Sec. 2056(b)(7) defines a qualifying income interest for life as a right to all income from the property, payable annually or at more frequent intervals and over which no person has a power of appointment in favor of any person other than the surviving spouse. A lifetime interest in a personal residence has been deemed to meet the criteria of a QTIP, provided the surviving spouse has a right of enjoyment in that property for the duration of her life. This right of enjoyment has been interpreted as both a right to lifetime occupancy and a right to the economic benefits of rental in the event that occupancy ceases.

The language in the decedent's will effectively conveyed a life estate in the residence to the surviving spouse. This life estate qualified for QTIP status, even though the surviving spouse was obligated under the instrument to personally bear normal maintenance costs, a burden that was deemed consistent with the obligations imposed on the life tenant of a legal life estate. A similar result occurred in IRS Letter Ruling 9047051.(112)

However, in IRS Letter Ruling (TAM) 9033004,(113) QTIP status was denied when the surviving spouse's interest in the personal residence was limited to a right of occupancy. Since the surviving spouse's economic interest in the residence would terminate if she ceased occupying the residence, the IRS concluded that such a right was not equivalent to a qualifying income interest. Finally, in IRS Letter Ruling (TAM) 9040001,(114) the IRS concluded that 50% of a personal residence's value qualified for QTIP status when the decedent's will gave his spouse a bare right of occupancy, but provided that if she vacated the residence, the property would be sold and 50% of the proceeds would be distributable to the surviving spouse.

Planning hints: The above rulings indicate that a life interest in a personal residence will qualify for QTIP status only if that interest is deemed equivalent to a legal life estate under local law. A bare right of occupancy, under which the surviving spouse's interest terminates on her ceasing to occupy the property, will not meet the QTIP requirements.

It should be noted that the Eleventh Circuit has added a degree of ambiguity to this entire area. In Peacock,(115) the decedent devised to her husband the right to occupy their personal residence as long as he desired. The Eleventh Circuit found for the taxpayer by interpreting the devise, within the context of local law, as a bequest of a legal life estate, rather than a limited right of occupancy. While the IRS's position concerning a right of occupancy may be appropriate, courts may be willing to find language in local law that will extend the spouse's interest to a full legal life estate. Irrespective of the holding in Peacock, however, planners are advised to convey the equivalent of a legal life estate in a residence if QTIP status is intended.

* Valid QTIP does not require accumulated undistributed income to be paid to surviving spouse's estate In Howard,(116) the decedent's will provided for a marital trust, directing that income be paid at least annually to the surviving spouse. The trust instrument also directed that income accrued or held undistributed by the trustee at the termination of any interest would go to the next beneficiaries of the trust. The Ninth Circuit, reversing the lower court, held that the trust qualified for QTIP status.

Critique: Howard arose from a novel attempt at postmortem planning. Initially, the federal estate tax return was filed electing QTIP status for the trust and claiming the marital deduction. Shortly thereafter, the surviving spouse died. Between the dates of the two spouses' deaths, the marital trust had increased significantly in value. The taxpayer noted a regulatory requirement that a power of appointment marital trust will not qualify unless accrued and undistributed income is payable to the surviving spouse's estate. The taxpayer asserted that this requirement also applies to QTIP trust and that the QTIP election was invalid. An amended federal estate tax return was filed for the original decedent. The federal estate tax return of the surviving spouse excluded the marital trust assets from her gross estate.

The Ninth Circuit disagreed. It noted that, while the income distribution requirements for a general power of appointment trust and a QTIP are expressed in substantially the same manner, the characters of the interests are significantly different. Finally, the court agreed with the IRS's assertion that Sec. 2044, which statutorily mandates the inclusion of QTIP property in the survivor's gross estate, effectively eliminated any technical need that accumulated income be payable to the survivor's estate.

Planning hints: The Ninth Circuit and the IRS appear to be correct. Further, the holding in Howard eliminates a potential ambiguity on this issue. Initially, when the lower court ruled for the taxpayer, the IRS indicated that it would administratively treat dispositive provisions comparable to those found in Howard as qualifying for QTIP. While it seems unlikely that the IRS will pursue further litigation, drafters are left in a quandary as to whether the lower court's or the IRS's position will prevail. If enacted, recently proposed legislation will resolve this issue prospectively.

* Testamentary trust with income to surviving spouse for life and remainder to charity qualifies for QTIP In IRS Letter Ruling 9101010,(117) the decedent's will transferred property to a trust, the income of which was payable to the surviving spouse for life. In addition, the surviving spouse had an annual power to withdraw either $5,000 or 5% of the trust corpus annually. On the surviving spouse's death, the entire trust corpus was distributable to a private foundation and/or charitable beneficiaries. The IRS found that the bequest qualified as a QTIP and that the surviving spouse's estate would be entitled to a charitable deduction under Sec. 2055.

Critique: The IRS noted that the surviving spouse's interest in the trust constituted a qualified income interest within the meaning of Sec. 2056(b)(7). Further, Sec. 2044 provides that the gross estate of the surviving spouse will include the value of all property with respect to which a QTIP election has been made. As such, the QTIP trust is deemed for federal tax purposes as property passing from the surviving spouse. Since the QTIP trust was includible in the gross estate of the surviving spouse and, on death, was deemed to pass from the spouse to qualified charitable beneficiaries, the charitable deduction under Sec. 2055 is available. A similar result occurred in IRS Letter Ruling 9043016.(118)

* Family agreement results in loss of marital deduction In IRS Letter Ruling 9101025,(119) the decedent's will made a number of specific bequests to family members and directed that the residue pass to a trust for the benefit of her surviving spouse. As the aggregate specific bequests were substantially larger than the residue, federal and state death taxes would have resulted in a complete abatement of the spousal bequest. As such, the surviving spouse elected his statutory share of the probate estate. Under New York law, the spouse's elective share was equal to one-third of the probate estate or approximately $677,000.

The surviving spouse entered into an agreement with the family under which assets would be conveyed to the spousal trust established under the decedent's will. The effect of this agreement was to convert his statutory one-third fee interest into a life estate. The IRS ruled that no marital deduction was available.

Critique: Regs. Sec. 20.2056(e)-2(c) provides that when a surviving spouse elects to take against a will, the property interests described under the will are deemed not to have passed to the spouse, but the property passing by virtue of the election is deemed to pass from the decedent and qualify for the marital deduction. As such, had the surviving spouse done nothing more, his $677,000 one-third statutory interest would have qualified for the marital deduction.

Regs. Sec. 20.2056(e)-2(d)(2) deals expressly with controversies involving a decedent's will. It provides that a property interest assigned or surrendered to a surviving spouse as a result of an agreement resolving a will controversy will be deemed to have been received from the decedent only if the assignment was a bona fide recognition of an enforceable right. The mere fact that the assignment was made as a result of a good faith settlement is not sufficient.

In Letter Ruling 9101025, the IRS noted that the settlement resulted in the creation of a right that was totally different from that resulting from the spouse's statutory election. Further, nothing existed in New York law that provided a surviving spouse with an enforceable right to convert a fee interest received under a statutory election into a life estate in trust. As such, the interest in trust was deemed to have arisen out of the agreement, rather than having passed from the decedent. In consequence, an essential element of the marital deduction was not present.

Planning hints: The consequences of the agreement in Letter Ruling 9101025 appear disastrous. While some forethought obviously was employed in structuring the economic elements of the transaction, clearly the estate's advisers failed to address the federal estate tax consequences of their action. Presumably, the same economic result would have occurred had the surviving spouse received his fee interests in the probate estate and, thereafter, transferred that interest to a revocable trust, naming the estate's legatees as remaindermen. The one thing missing, obviously, would be the level of certitude that the settlement agreement imposed on the ultimate disposition of the trust property.

* Third-party guarantees could imperil marital deduction In IRS Letter Ruling 9113009,(120) the taxpayer guaranteed third-party loans made to his children and to entities owned by his children. In addition, he personally guaranteed obligations of corporations or other business entities in which he held an equity interest.

The taxpayer established a revocable trust that provided for two marital trusts. The first was an estate trust that was to be funded with a pecuniary amount equal to two times the "net value cost" of making payments on guarantees still outstanding at his death. The "net value cost" was defined as the present value of all payments the estate trust may reasonably be expected to make on the guarantees given by the taxpayer. The remainder went to a separate trust that would qualify for QTIP status.

The IRS ruled that a marital deduction was available with respect to the estate trust only to the extent that its federal estate tax value exceeded the face amount of outstanding guarantees. Further, no marital deduction would be available with respect to the QTIP if any portion of the guarantees outstanding at death could be satisfied out of assets assigned to that trust.

Critique: In Part II of this article, the authors discussed the federal gift tax consequences of the taxpayer's donative guarantees of loans obtained by his children or by companies owned by his children.(121) While the IRS's conclusions in the gift tax area are subject to question, its conclusions in the marital deduction area are even more controversial.

The IRS's disallowance of the marital deduction to the extent the estate trust could be required to make payments under the guarantees is premised on Sec. 2056(b)(1). That section disallows the deduction if the occurrence of an event or contingency can cause the surviving spouse's interest to fail and the interest to pass to another person. The IRS analyzed several cases that disallowed the marital deduction to the extent death taxes and administrative expenses could be borne by the marital bequest.(122) The IRS also noted that Regs. Sec. 20.2056(b)-4(b) reduces the marital deduction by the amount of any mortgage or encumbrance imposed on the surviving spouse.

The IRS also disallowed the entire QTIP trust if any portion of the trust could be called on to pay a guarantee. This ruling is premised on the notion that Sec. 2056(b)(7) is violated if any person other than the surviving spouse could have an interest in the trust.

Finally, the IRS observed that no deduction is allowed under Sec. 2053(a)(3) for a contingent debt except to the extent the estate pays the indebtedness and cannot receive reimbursement from the primary obligor.(123)

In today's litigious and complex business environment, contingent obligations are common. The IRS's position would seem to threaten the marital deduction of most landowners (due to the potential of a contingency for toxic cleanup expenses), many business persons (due to guarantees of business debts and/or potential shareholder suits), persons involved in car accidents (due to potential liability claims in excess of insurance coverage) and many professionals (due to potential underinsured malpractice claims), among others.

Aside from equity grounds, the authors believe that the IRS's legal position is tenuous. The surviving spouse receives a property interest that is subject to a contingent debt, not a property interest that may terminate or fail within the meaning of Sec. 2056(b)(1). Unlike death taxes and administration expenses, the contingency of payment of a guarantee arises during life, not as a result of or following death. A will that directs or permits taxes and postdeath expenses to be paid from a marital share expressly enhances the portion of the estate passing to non-spouse beneficiaries and directly reduces the interest passing to the surviving spouse. The existence of contingent obligations arising before death does not result in a shifting of interests after death which causes the "passing" of the surviving spouse's interest to another beneficiary.

The IRS apparently views a creditor under a contingent guarantee as having a prohibited interest in the trust. It is simply unprecedented to view a creditor, whether actual or contingent, as having an interest in a trust. If the IRS is upheld in this view, a QTIP election could fail if the decedent's personal residence is subject to a mortgage and passes or could pass to the QTIP trust.

Planning hints: It truly is unfortunate when the IRS takes novel or bizarre positions, particularly when they relate to common family and business transactions that have been accepted without challenge for decades. One certainly may question why the taxpayer's adviser pressed the IRS for this ruling. The authors understand that the IRS is reconsidering its conclusions as a result of the howls of anguish from taxpayers and advisers subsequent to this ruling. Although the authors hope and believe the IRS will lose if it chooses to litigate its position, the sheer magnitude of the risk of loss is frightening and may compel taxpayers to consider contortions to avoid the risk. For example, the guarantee of a child's modest home loan could threaten all of the parent's QTIP marital deduction.

Strangely enough, this issue can be avoided if the parent borrows directly from the lender and then loans the funds to his child for a bona fide note. At death, the parent's estate includes a note receivable and a deductible debt with little or no net effect. Unfortunately, parents typically prefer the guarantee approach because children have a greater motivation to repay debt owed directly to third-party lenders.

Assuming the contingent creditor's legal claims can be isolated, an outright or estate trust bequest subject to the claims can protect the remainder of the marital deduction for property passing to the QTIP trust. Of course, the IRS's view would disallow any deduction for the outright or estate trust bequest to the extent of the face amount of the guarantees.

Miscellaneous Estate and Trust Matters

Miscellaneous developments affecting estates and trusts included the following.

* Various rulings addressed trust qualifications as S corporation shareholders. * A decedent's estate was denied the prior transfer tax credit under a simultaneous death provision. * The IRS concluded that refund suits are barred until all Sec. 6166 payments are made. * The equitable recoupment doctrine was not applicable to allow a refund barred by the statute of limitations.

* Rulings dealing with QSST status A number of letter rulings were issued on whether certain trusts were qualified holders of S corporation stock. Sec. 1361 provides that grantor trusts and qualified subchapter S trusts (QSSTs) are the only fiduciary entities permitted to hold S corporation stock for other than a transitional period. Sec. 1361(d)(3) defines a QSST as a trust that distributes all of its income, within the meaning of Sec. 643(b), currently to one individual who is a citizen or resident of the United States. In addition, the terms of the trust must require that --during the life of the current income beneficiary, there will be only one income beneficiary of the trust; --any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary; --the income interest of the current income beneficiary must terminate on the earlier of such beneficiary's death or the termination of the trust; and --on termination of the trust during the life of the current income beneficiary, the trust will distribute all of its assets to such beneficiary.

The following rulings represent an interpretive application of these requirements.

In Letter Ruling 9035048,(124) the IRS ruled that a trust holding S corporation stock qualified as a QSST even though under the terms of the instrument and local law the beneficiary's income interest did not extend to undistributed S corporation earnings. With respect to the definition of distributable income, the IRS held that the exclusion of undistributed S corporation earnings from trust accounting income did not imperil QSST status, provided the exclusion was consistent with the appropriate local law. Of course, the qualification of the trust as a QSST is dependent on the beneficiary executing an election to have the trust, to the extent of its holdings in S corporation stock, deemed owned by her for federal income tax purposes. As such, while no requirement exists that undistributed earnings of the S corporation be distributed, the beneficiary would be taxed on those earnings under the grantor trust rules.

In Letter Ruling 9035052,(125) the IRS dealt with an irrevocable trust that provided for mandatory income distributions to the beneficiary and also gave the beneficiary both a lifetime and testamentary special power of appointment. Under neither power could the beneficiary appoint to himself, his creditors or his estate. The inter vivos power was deemed in violation of the QSST rules since income or corpus could be diverted, during the term of the trust or the beneficiary's lifetime, to a third party. However, if the beneficiary releases the inter vivos power of appointment, the trust would qualify for QSST status.

In Letter Ruling 9044045,(126), the IRS ruled that a provision in a trust agreement authorizing a power of accumulation over income in the event the trust ceases to hold S corporation stock was not fatal to a QSST election. It is sufficient if, during the period S corporation stock is held by the trust, the instrument either mandates annual income distributions or income is in fact distributed annually. The IRS also stated that, on disgorgement of the S corporation stock, the trust will cease QSST status on the first day of the first tax year beginning after the year in which the trustees fail to distribute currently all income of the trust.

In Letter Ruling 9052048,(127) the IRS ruled that when two separate QSSTs exist, the beneficiary of each being a spouse of the other, these spousal beneficiaries are treated as a single shareholder of the S corporation. This ruling is relevant to meeting the 35-shareholder limitation of Sec. 1361(b)(1)(A).

* Decedent's estate denied prior transfer tax credit for usufruct In Carter,(128) the decedent and his spouse were killed in an automobile accident. While it was not known which spouse died first, Louisiana law created a presumption that the decedent's wife predeceased. In an amended federal estate tax return of the husband, the estate claimed a refund of approximately $292,000 attributable to a prior transfer tax credit claimed for the decedents usufruct interest in his wife's estate. The Fifth Circuit held for the IRS, denying the availability of any credit.

Critique: The estate asserted that the decedent's usufruct was an indeterminate interest within the meaning of Regs. Secs. 20.2031-7 and -10. As such, the mortality tables contained in those sections applied irrespective of the actual amount of time between the decedent's succession to the usufruct and his death. The IRS, on the other hand, asserted that when a transferor and transferee die in a common disaster, a usufruct passing between them is valueless.

The Fifth Circuit noted that Regs. Sec. 20.2013-4(a) directs that the amount of prior transfer tax credit with respect to an indeterminate interest, such as a life estate or usufruct, should be calculated on "the basis of recognized valuation principles (see especially [Regs. Secs.] 20.2031-7 and 20.2031-10)." The parenthetical phrase in this regulation was interpreted by the court as clearly indicating that while the mortality tables must ordinarily be applied to such an interest, under extraordinary circumstances alternative recognized valuation principles could be appropriate.

The court concluded that the facts under consideration were extraordinary within the meaning of the regulation. In fact, the virtually simultaneous deaths of both spouses was a certainty and no physical evidence existed that allowed the court to ascertain which spouse had in fact survived. The presumed survival of the husband was deemed a legal fiction imposed by state statute.

In holding for the government, the court cited the Fourth Circuit's opinion in Lion,(129) which dealt with almost identical facts. Further, the court noted that in Provident Trust Co.,(130) the mortality tables were also ignored for the value of a charitable remainder contingent on the life tenant's not having any issue, when the life tenant had undergone a hysterectomy and was incapable of bearing children.

Finally, the Fifth Circuit distinguished the facts in Lion, Carter and Provident from those in Ithaca Trust,(131) in which mortality tables were used to value a life interest and the transferee died within six months of the transferor. The distinguished feature was that, as of the decedent's date of death in Ithaca Trust, the impending death of the transferee was neither known nor was it a certainty. As such, the ordinary valuation methods mandated under Regs. Secs. 20.2031-7 and -10 were deemed applicable.

Planning hints: Previously, the courts had virtually unanimously held that the mortality tables for valuing a life estate or usufruct were applicable in most circumstances. As such, subsequent information concerning the premature death of a life tenant was not alone sufficient to make the mortality tables inappropriate. However, the authors believe that the reasoning of the Fifth Circuit in Carter is compelling. For all intents and purposes, a simultaneous death had occurred and an undue windfall could have been realized by the taxpayer had a credit been allowed using mortality tables in light of the clear facts and circumstances.

* Failure to pay all of tax bars refund suit In 1958, in Flora,(132) the Supreme Court concluded that a refund suit could not be asserted in a district court or the Court of Claims until full payment of the disputed tax liability is made. The IRS subsequently issued GCM 35696,(133) which concluded that the Flora full payment rule should not be made applicable to an estate tax under which Sec. 6166 installment payments have been elected. The underlying rationale for the memorandum was that the assertion of the full payment rule would have the effect of negating the benefits of Sec. 6166, penalizing the taxpayer by forcing him to wait 10 years or more before suit may be instituted.

In 1989, in Rocovich,(134) the Claims Court held that a Sec. 6166 installment election did not warrant an exception to the full payment rule described in Flora. Further, in Manning,(135) the district court criticized the IRS's position. In GCM 39839,(136) the IRS reconsidered its position in GCM 35696, in light of the above cases, and concluded that it no longer had any basis for not following Flora in a Sec. 6166 election situation. Consequently, the IRS now will assert the Flora principle in Sec. 6166 refund suits to prohibit district and claims court actions until the full estate tax is paid.

* Equitable recoupment will not salvage claim for refund when statute of limitations has run In Bedell,(137) the decedent acquired a limited partnership interest in 1976 for $30,000. A Schedule K-1 was issued disclosing a deductible loss of approximately $120,000, which was included in his 1976 income tax return. He died in 1977. The partnership interest was valued at zero on his federal estate tax return.

On audit, the IRS asserted a deficiency based on a revaluation of the partnership interest and the inclusion of certain life insurance proceeds. After a long period of negotiation, a final settlement was reached and a closing letter issued reflecting a zero valuation of the partnership interest and a reduction in the amount of includible proceeds. Form 890, Waiver of Restrictions on Assessment, included the following language: "Reservation: The estate reserves the right to file a claim for refund, for any debt of the estate that arises from an income tax audit of the decedent's personal income tax returns." In February 1980, an additional estate tax payment was made under this agreement.

In 1982, the entire limited partnership loss was disallowed and a substantial 1976 income tax deficiency was assessed. After negotiations, the amount of deficiency plus interest was paid in March 1984. In October 1984, a refund claim was filed, asserting a reduction in federal estate tax for the additional amount of federal income taxes incurred by reason of the partnership loss disallowance. Although the IRS responded with an amended estate tax closing letter showing a reduced estate tax, it failed to send a refund. This refund was denied due to the lapse of the statute of limitations. The District Court of Southern New York held for the IRS.

Critique: The court noted that throughout both the estate and income tax audit processes, both the field and appeals agents recognized that an increase to the federal income tax liability would trigger a federal estate tax deduction. This recognition also occurred on Form 890 and on the amended estate tax closing letter. However, notwithstanding the recognition of the accuracy of the claim in the final closing letter, the IRS refused to act on the actual payment of a refund.

The court concluded that it was bound by the statute of limitations and that a claim for refund with respect to a final estate payment made in 1980 could not statutorily be acted on with respect to a claim filed in 1984--almost four years after the payment of such tax.

The court then addressed the taxpayer's assertion that equitable recoupment should preserve the deduction. The court noted that the concept of equitable recoupment was first applied in Bull,(138) and its purpose "is to relieve parties from the unfair application of statutes of limitations in certain circumstances." Hoewever, the court also noted that the Bull decision was clear in its assertion that equitable recoupment is a defensive, rather than offensive, doctrine.

Within this context, the court stated that the appropriate application of the equitable recoupment doctrine is the offset or reduction of a tax liability by a potential refund that would result from the same transaction, but was barred by the statute of limitations. However, in Bedell, both the federal income tax and the final estate tax had been paid. Therefore, the taxpayer was using equitable recoupment offensively, in that the taxpayer sought a refund of, rather than an offset against, taxes.

In arriving at this decision, which the court recognized was harsh, the court noted that equitable recoupment could and should have been applied during the negotiations associated with the audit of the partnership and the payment of additional income taxes on the decedent's return. At that time, the amount of federal estate tax reduction attibutable to the increased tax liability could appropriately be treated as an offset against the aggregate amount of income taxes deemed due. In other words, the taxpayer did not assert its remedies at the appropriate time.

Finally, with respect to the events described above, District Judge Haight said, "While the IRS's processing of this claim cannot be regarded as its finest hour of service to taxpayers, I am constrained by statute and controlling authority to grant the government's motion for summary judgment dismissing the complaint as barred by the statute of limitations."

Planning hints: The result to the taxpayer in Bedell approaches tragedy. An estate tax reduction, which all parties agreed was appropriate, was lost because of inadequate attention to issues concerning the statute of limitations and the appropriate time to assert relief under the equitable recoupment doctrine. This must be viewed as a failure on the part of the taxpayer's advisers.

(101)Est. of Samuel I. Levitt, 95 TC 289 (1990). (102)Est. of Bradley B. Blair, TC Memo 1988-296. (103)Est. of McCamant C. Higgins, TC Memo 1991-47. (104)Est. of Louise E. Cubberly Kendall, TC Memo 1990-547. (105)Est. of Carl I. Heim, 914 F2d 1322 (9th Cir. 1990)(66 AFTR2d 90-6009, 90-2 USTC [P] 60,040). (106)Harry D. Schroeder (exec. Est. of Thomas J. Woodmansee), 925 F2d 1547 (10th Cir. 1991)(67 AFTR2d [P] 149,023, 91-1 USTC [P] 60,059). (107)IRS Letter Ruling (TAM) 9104003 (9/14/90). (107a)Est. of Arthur M. Clayton, Jr., 97 TC No. 22 (1991). (108)IRS Letter Ruling 9037003 (6/4/90). (109)Est. of John T. Higgins, 91 TC 61 (1988), aff'd, 897 F2d 856 (6th Cir. 1990)(65 AFTR2d 90-1231, 90-1 USTC [P] 60,011). (110)Harry C. Spohn Estate, Charles Barber, exec., N.D. Ind., 1990 (66 AFTR2d 90-5982, 90-2 USTC [P] 60,027). (111)IRS Letter Ruling 9046031 (8/20/90). (112)IRS Letter Ruling 9047051 (8/28/90). (113)IRS Letter Ruling (TAM) 9033004 (date not given). (114)IRS Letter Ruling (TAM) 9040001 (6/8/90). (115)Est. of Mary Edwards Helms Peacock, 914 F2d 230 (11th Cir. 1990)(66 AFTR2d 90-6015, 90-2 USTC [P] 60,051). (116)Est. of Rose D. Howard, 910 F2d 633 (9th Cir. 1990)(66 AFTR2d 90-5994, 90-2 USTC [P] 60,033), rev'g 91 TC 329 (1988). (117)IRS Letter Ruling 9101010 (10/4/90). (118)IRS Letter Ruling 9043016 (7/26/90). (119)IRS Letter Ruling 9101025 (10/10/90). (120)IRS Letter Ruling 9113009 (12/21/90). (121)See Abbin, Carlson and Nager, "Significant Recent Developments in Estate Planning (Part II)," 22 The Tax Adviser 669 (Oct. 1991), at note 69 and accompanying text on pages 673-674. (122)Est. of Milton S. Wycoff, 506 F2d 1144 (10th Cir. 1974)(35 AFTR2d 75-1557, 74-2 USTC [P] 13,037); Emil L. Jeschke (exec. Est. of Emil J. Jeschke), 814 F2d 568 (10th Cir. 1987)(59 AFTR2d 87-1235, 87-1 USTC [P] 13,713); Elizabeth P. Ballantine (exrx. Est. of Percy Ballantine), 293 F2d 311 (5th Cir. 1961)(8 AFTR2d 6042, 61-2 USTC [P] 12,029). (123)Samuel H. Wragg, 141 F2d 638 (1st Cir. 1944)(32 AFTR 453, 44-1 USTC [P] 10,098); Rev. Rul. 84-42, 1984-1 CB 194. (124)IRS Letter Ruling 9035048 (6/4/90). (125)IRS Letter Ruling 9035052 (6/5/90). (126)IRS Letter Ruling 9044045 (8/3/90). (127)IRS Letter Ruling 9052048 (10/3/90). (128)Est. of Andrew P. Carter, 921 F2d 63 (5th Cir. 1991)(67 AFTR2d [P] 149,022, 91-1 USTC [P] 60,054), rev'g E.D. La., 1989 (90-1 USTC [P] 60,003). (129)Est. of Gloria A. Lion, 438 F2d 56 (4th Cir. 1971)(27 AFTR2d 71-1655, 71-1 USTC [P] 12,745). (130)Provident Trust Co., 291 US 272 (1934)(13 AFTR 861, 4 USTC [P] 1229). (131)Ithaca Trust Co., 279 US 151 (1929)(7 AFTR 8856, 1 USTC [P] 386). (132)Walter W. Flora, 357 US 63 (1958)(1 AFTR2d 1925, 58-2 USTC [P] 9606). (133)GCM 35696 (2/27/74). (134)John G. Rocovich, Jr., Cls. Ct., 1989 (64 AFTR2d 89-5942, 89-2 USTC [P] 13,819), aff'd, Fed. Cir., 1991 (67 AFTR2d [P] 149,030, 91-1 USTC [P] 60,072). (135)Richard DeY Manning (exec. of Norman Norell, Deceased), S.D. N.Y., 1983 (53 AFTR2d 84-1584). (136)GCM 39839 (date document numbered 3/5/91). (137)Leah Bedell (exrx. Est. of Albert Bedell), S.D. N.Y., 1991 (91-1 USTC [P] 60,057). (138)Ernest M. Bull (Sole Surviving Executor and Trustee of Est. of Archibald H. Bull), 295 US 247 (1935)(15 AFTR 1069, 35-1 USTC [P] 9346).

Byrle M. Abbin, CPA Partner Arthur Andersen & Co. Washington, D.C. David K. Carlso, CPA Principal Arthur Andersen & Co. Sarasota, Fla. Ross W. Nager, CPA Partner Arthur Andersen & Co. Houston, Tex.