Purchase of QTIP remainder interest for FMV is a gift.

In Rev. Rul. 98-8, the IRS ruled that a surviving spouse purchases the remainder interest in qualified terminable interest property (QTIP) makes a gift even though the surviving spouse pays fair market value (FMV) for the remainder interest. The amount of the gift is the greater of the remainder interest or the property given for it. The rationale for this ruling is that, if the surviving spouse does not purchase the remainder interest, it will nevertheless be included in the surviving spouse's gross estate. If the surviving spouse purchases the remainder interest, however, the property given in exchange for it will not be in the gross estate; thus, this property must be subject to the gift tax.

In calculating the taxable estate, Sec. 2056(a) allows a marital deduction for property passing to the surviving spouse. The property is then taxed in the estate of the surviving spouse at death under Sec. 2033. Sec. 2056(b)(1) prohibits a marital deduction for terminable interest property, such as an income interest in property, because terminable interest property is not included in the estate of the surviving spouse. Sec. 2056(b)(7) provides an exception for QTIP. The estate of the first spouse to die receives a marital deduction for QTIP, even though the will of this spouse determines who receives the remainder interest. To qualify for this exception, the surviving spouse must receive all of the income from the property payable at least annually, and the executor of the estate of the first spouse to die must make a QTIP election. If these requirements are satisfied, the property is included in the surviving spouse's estate under Sec. 2044. The objective of the marital deduction is therefore to defer the estate tax and not to allow property to escape taxation completely.

Sec. 2519 specifies that any disposition of all or part of a Sec. 2056(b)(7) QTIP income interest is treated as a gift of the entire remainder interest. The legislative history broadly interprets "disposition" to include disposition "by gift, sale, or otherwise." Sec. 2511 (a) applies the gift tax to transfers regardless of their form or the nature of the property. Sec. 2512(b) specifies that if property is transferred for less than FMV, the excess of FMV over the consideration received is a gift.

Example: D's will established a trust that pays all income annually to S for life, with the property to be distributed to D's children after S's death. S was not given a general power of appointment over the trust property. D's executor made a QTIP election. The value of the income interest is $100,000. If S dies when the FMV of the trust property is $300,000, $300,000 would be included in S's gross estate under Sec. 2044. If instead, S sells the income interest to D's children for $100,000, S has made a gift of $200,000, the value of the remainder interest under Sec. 2519. Thus, QTIP property is subject to transfer tax when the surviving spouse disposes of the income interest or dies, whichever occurs first.

If S sells only 25% of the income interest for $25,000, S still has made a gift of $200,000 under Sec. 2519. (Neither the regulations nor the legislative history provide any rationale for this requirement. Perhaps it is to discourage Sec. 2519 transfers, as well as to prevent a Sec. 2519 transfer equal to, but not exceeding, the Sec. 2505(a) unified credit equivalent, which is $625,000 in 1998.) Second, if S gives (rather than sells) the entire income interest to the children, S has made an additional gift of $100,000 under Secs. 2511 (a) and 2512(b).

Neither the statutes nor the regulations address the surviving spouse's purchase of a QTIP remainder interest. In Rev. Rul. 98-8, the QTIP trust was terminated, leaving the surviving spouse with assets equal to the value of the income interest after paying the remainderman assets equal to the value of the remainder interest. The surviving spouse argued that there was no gift because he received full and adequate consideration for the assets transferred to the remainderman. The IRS reasoned that acquiring the remainder interest results in a disposition of the income interest and leaves the surviving spouse in the same position as selling the income interest. To clarify the Service's position, assume that in the example, the surviving spouse paid $200,000 (in cash or other property) for the remainder interest, the trustee distributed the $300,000 in assets to S and the income interest terminated. S would be left with a net $100,000 increase in assets (the value of the income interest). Also, the surviving spouse and the remainderman have each received the value of their proportionate interests in the trust property. To avoid allowing the $200,000 to escape transfer tax, it must be subject to gift tax under Sec. 2519.

The IRS offered two other reasons for its ruling in Rev. Rul. 98-8. First, the remainder interest purchased by the surviving spouse did not constitute "adequate and full consideration" as required by Sec. 2512(b), because the remainder interest did not increase the value of the surviving spouse's gross estate, given that it would have been included under Sec. 2044 if not so purchased. Second, the Service also cited Novotny, 93 TC 12 (1989), in which the Tax Court ruled that the surviving spouse made a Sec. 2519 gift when she and the remainderman each received their proportionate shares of the proceeds from the sale of QTIP.

One motive for the surviving spouse's purchase of the remainder interest would be to transfer assets to the remainderman. Given Rev. Rut. 98-8, such a purchase would be advisable only if the QTIP were rapidly appreciating. This transaction would prevent the appreciation from being taxed in the surviving spouse's gross estate even though the Sec. 2519 gift would be added to the taxable estate under Sec. 2001(b). The entire remainder interest should be purchased; if the surviving spouse purchased only part of the remainder interest, the Service would probably treat that as the purchase of the entire interest under Sec. 2519 and Rev. Rul. 98-8. If appreciation is not an issue, the remainder interest should not be purchased. Instead, the surviving spouse should make lifetime gifts to the remainderman, using the Sec. 2503(b) $10,000 annual gift tax exclusion, even though such gifts would transfer assets more gradually to the remainderman.