QTIP cannot escape taxation in both spouses' estates.

In Estate of Mildred Letts, 109 TC No. 15 (1997), the Tax Court held that the duty of consistency required a surviving spouse's gross estate to include a terminable interest in property, even though the estate of the first spouse to die did not make a qualified terminable interest property (QTIP) election. The estate of the first spouse to die (which the IRS did not audit) had incorrectly claimed the marital deduction for the property, but the assessment of additional tax against that estate was barred by the statute of limitations (SOL).

In calculating a taxable estate, Sec. 2056(a) allows a marital deduction for property passing to a surviving spouse; this property is then taxed in the surviving spouse's estate on death. However, Sec. 2056(b)(1) prohibits a marital deduction for terminable interest property when, for example, the surviving spouse has only an income interest in the property. Since terminable interest property is not included in the surviving spouse's estate, allowing the marital deduction in the estate of the first spouse to die would permit the property to escape taxation in both spouses' estates--which would be contrary to the marital deduction's objective.

Sec. 2056(b)(7) provides an exception to the terminable interest rule for QTIPs. This exception allows the estate of the first spouse to die to obtain a marital deduction for property, even though the surviving spouse has no control over the property's ultimate disposition. (The will of the first spouse to die determines who receives the remainder interest.) To qualify for this exception, the surviving spouse must receive the property's income payable at least annually, no person can have a power to appoint any part of the property to anyone except the surviving spouse during her lifetime 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.

Sec. 6501 (a) generally imposes a three-year SOL on the assessment of any Federal tax. In certain situations, the courts have developed the duty of consistency to allow the Service to assess additional tax for a year not closed by the SOL to compensate for the inability to assess the additional tax for a closed year. For the duty of consistency to apply, the following conditions must be satisfied:

1. The taxpayer represented a fact or reported an item in one tax year.

2. The IRS acquiesced or relied on that fact for that year.

3. After that year is closed by the SOL, the taxpayer changes the representation for the current-year's return.

The Service can act as if the previous representation were true, even if it is not, in examining the current-year's return. Consistency prevents the taxpayer from benefiting from an inequity of his own making.

Estate of Letts

James Letts died in 1985 with a $1,877,372 gross estate. He was survived by his spouse, Mildred, and their two children. His estate claimed a $1,317,969 marital deduction. Of this amount, his will designated $1,000,264 for a trust with the following provisions: income payable quarterly to his surviving spouse and remainder to his descendants. James's will authorized the executors (Mildred and the children) to make a QTIP election. The CPA who prepared the estate tax return (which James's son signed) checked "no" to the question of whether a marital deduction was claimed for QTIP. The CPA described the trust on Schedule M as a "qualified marital trust." However, he listed no property as QTIP, did not indicate whether the trust property was terminable interest property and did not include a copy of James's will with the return. As a result of overstating the marital deduction by $1,000,264, no estate tax was paid. The IRS did not audit the return.

Since the SOL barred the Service from assessing James's estate, it included the trust property in Mildred's estate under the duty of consistency and determined a $461,601 estate tax deficiency. Consistency was the IRS's only argument; the estate claimed that there was no statutory authority for including the trust property in Mildred's estate, as she had only a terminable interest and James's estate did not make the QTIP election.

The Tax Court first determined that Mildred's and James's estates were sufficiently related to constitute one taxpayer for consistency purposes: The parties were married; the estates were a single economic unit with the two children as beneficiaries of both estates; Mildred was an executrix of James's estate; one child signed both estate tax returns and the other child also signed Mildred's estate tax return. (Both children were executors of both estates.)

Turning to the consistency requirements, the court determined that all three requirements were satisfied. Since James's estate tax return claimed the marital deduction but did not make the QTIP election, the court concluded that the estate represented that the trust property was not terminable interest property. Even though the Service did not examine the return, the court ruled that the IRS relied on this representation because the fact that the property was actually terminable interest property was inadequately disclosed. (For example, the estate did not include a copy of the will with the return.) Finally, on Mildred's estate tax return, her estate claimed the trust property was terminable interest property, thereby changing the representation that was made on James's estate tax return. Therefore, the court decided that the trust property must be added to Mildreds gross estate.

Planning

If the estate of the first spouse to die incorrectly claims the marital deduction on terminable interest property and the Service does not discover this mistake before the expiration of the SOL, the IRS can use Estate of Letts to tax the property in the surviving spouse's estate. However, it is not clear how the court would have decided if James's children were from a previous marriage and Mildred left her estate to a third party. Would the estates of the two spouses be sufficiently related to constitute one taxpayer for consistency purposes? Also, if James's estate tax return had contained his will, would this disclosure be sufficient to prove that the Service should have known the property was terminable interest property? If so, the IRS would not have satisfied the reliance requirement.

FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, AND CLAYTON K. SAGER, PH.D., CPA, ASSOCIATE PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI (NOT ASSOCIATED WITH BDO SEIDMAN)