Technical advice shows how to lose a marital deduction.

IRS Letter Ruling (TAM) 9610004 is a good example of how tax planning can sometimes backfire. In the ruling, a decedent (D) died testate. His will established two trusts, a bypass trust and a power of appointment marital trust. D's spouse (S) would receive all of the income from the marital trust, and discretionary distributions of income and principal from the bypass trust.

Shortly after D's death, S and their two children petitioned the local court, requesting authority to withhold the will from probate and to administer the estate as if D had died intestate. The court granted the petition. Under state law, all of D's assets passed to S free of any trust.

In filing the estate tax return for D's estate, the personal representatives claimed a marital deduction for all of the estate assets, as they all passed to S by virtue of the agreement not to file the will. The agent examining the estate tax return challenged this treatment.

The Service ruled that none of D's assets qualified for the marital deduction. Under Sec. 2056(a), a marital deduction is allowed for any interest in property which passes or has passed from the decedent to the surviving spouse. The estate tax regulations recognize interests that pass to a spouse as a result of the settlement of a controversy. The controversy must involve the recognition of a spouse's enforceable rights in a decedent's estate. If there is a settlement agreement, it must result from an arm's-length adversarial proceeding between the parties; a petition filed in court, even if the court considers the merits of the claims, is not necessarily adversarial.

In this case, no party had asserted or planned to assert any legally enforceable claim. S did not assert her right to take an elective share against the will. No conflict was indicated that would make the agreement an arm's-length compromise. Thus, the property did not pass from the decedent to the spouse, but passed as a result of the agreement among the beneficiaries not to probate the will. The agreement also did not constitute a qualified disclaimer.

This TAM illustrates the pitfalls that can result when parties try to modify a well-drawn estate plan. It appears that S did not want her property to be held in trust, so the family chose this method to pass her the assets, causing an otherwise nontaxable estate to be subject to tax. While the TAM does not indicate the size of the estate or the amount of tax at issue, the result was obviously not what the parties had intended.