The IRS's general aversion to loan guarantees on QTIP trust planning.

A basic technique in marital deduction planning for over a decade has been to claim the maximum available marital deduction limited only by the amount sheltered by the unified credit. A credit shelter trust is often provided to use up the available unified credit. The exemption equivalent is payable to the credit shelter trust for the benefit of the surviving spouse for life with the remainder over to the children.

An opportunity for postmortem estate planning based on the actual value of a decedent-spouse's estate at death, as well as the financial requirements of the surviving spouse at such time, is commonly available, even in marginally taxable estates, through the use of a qualified disclaimer. Sec. 2518(b)(4) provides that a qualified disclaimer includes a disclaimed interest that passes without direction by the disclaimant either to the spouse of the decedent or to a person other than the disclaimant. A will provision might leave everything to the surviving spouse after certain specific bequests to others and a later provision might direct that any disclaimed bequests, including any disclaimed bequests of the surviving spouse, should pass to a trust under which the surviving spouse is given an income interest but no power of appointment. In addition to (or in lieu of) a credit shelter trust, such a trust might be designed to qualify under Sec. 2056(b)(7) as a qualified terminable interest property (QTIP) trust. The ability to delay most of a couple's combined estate planning until after the first death has led many spouses to add such contingent QTIP trusts to their wills.

Possible Consequences of Guarantees

to Marital Trusts

Now after more than a decade of the unlimited marital deduction and the QTIP trust, the Federal estate and gift tax consequences of guarantees on these fundamental techniques of testamentary planning must be considered. A guarantee might be used to help a child with a car loan or a home mortgage, or to start a new business or attend college. Yet such a guarantee may destroy existing marital deduction planning.

Sec. 2056 permits an estate tax marital deduction for property that passes to a surviving spouse and is not a terminable interest.(1) A "terminable interest" is an interest that will terminate or fail on the passage of time or on the occurrence of some contingency.(2)

Under Sec. 2056(b)(5), an interest in property passing from a decedent to a surviving spouse will qualify for the marital deduction if the surviving spouse is entitled to all of the income from the interest (or a specific portion of the property) together with a general power of appointment to appoint the interest (or a specific portion of the interest) to himself or his estate. The entire interest (or the specific portion) cannot be subject to a power in any other person to appoint a part to any person other than the surviving spouse (a "power of appointment trust").

Under Sec. 2056(b)(7), a surviving spouse's qualified income interest in a QTIP trust is not held to be a terminable interest. A "qualified income interest" exists if the surviving spouse is entitled to all of the income from the property payable at least annually and no person (including the surviving spouse) has a power during the spouse's life to appoint any part of the property to any person other than the surviving spouse.

In Letter Ruling 9113009,(3) the IRS ruled that the face amounts of any outstanding guarantees reduce the amount of the available estate tax marital deduction, yet are not deductible unless actually paid during the administration of the estate. The mere possibility of invasion of an otherwise qualified QTIP trust for payment of an outstanding guarantee, regardless of the amount of the guarantee, was found to cause the entire QTIP trust to fail to qualify for the estate tax marital deduction. The letter ruling also indicated that guaranteeing the loans of others is a transfer subject to the gift tax.

The IRS based its conclusion on the QTIP trust requirement that no person (including the surviving spouse) have a power during the spouse's life to appoint any part of the property to any person other than the surviving spouse. A power of appointment trust would be similarly affected as no person, other than the surviving spouse, may have a power during the spouse's life to appoint any part of the property to be deducted to any person other than the surviving spouse.

The ruling appears to be incorrect in light of other existing authorities and should be withdrawn and revised. This article will attempt to review these other existing authorities and offer planning alternatives to the ruling.

* QTIP trust requirement

A recent Tax Court decision, Est. of Manscill,(4) illustrates the extent of concern the courts have shown about this requirement. The will of a deceased spouse established a trust providing the surviving spouse with income for life. The trustee was allowed to invade principal for the benefit of the surviving spouse for maintenance and support. The trustee also had discretion, with the prior approval of the surviving spouse, to invade principal for the support of the decedent's daughter, who held a remainder interest in the trust. The court held that the terms of the trust violated the QTIP requirements of Sec. 2056(b)(7)(B)(ii)(II), stating that the section precludes anyone, including the surviving spouse, from having the power to appoint trust property to any person other than the surviving spouse. The estate's argument that any payments to the daughter would be the equivalent of distributions to the surviving spouse for the daughter's benefit was held to ignore the clear language of the will directing distributions to the daughter for her own support.

IRS Letter Ruling 9113009

The taxpayer from time to time provided his adult children with unsecured guarantees of loans made directly or indirectly to them ("gift guarantees"), or borrowed funds directly and then lent the funds that he had borrowed directly or indirectly to his children ("back-to-back loans"). The adult children were participants in various business ventures and acquired target companies. Without the guarantees or use of their parent's credit, the children may not have been able to obtain the loans or may have had to pay a higher interest rate to obtain them. In addition, the taxpayer had individually guaranteed obligations of companies in which the taxpayer was an equity participant ("personal guarantees"). The guarantees contained rights of subrogation as to each primary obligor. The guarantees provided that they would be binding on the taxpayer's estate in the event of the taxpayer's death.

Due to the gift and estate tax uncertainties associated with the guarantees, the taxpayer established a revocable inter vivos trust. The trust was to be divided, if the taxpayer's spouse survived the taxpayer, into an estate trust and a QTIP trust. Each trust was for the benefit of the surviving spouse and designed to qualify for the estate tax marital deduction. The estate trust was to be funded with an amount equal to two times the "net value cost" of the gift and personal guarantees, i.e., the then present value of all payments that the estate trust could reasonably be expected to pay on account of the guarantees. The trust provided that all guarantee payments were to be made exclusively from the estate trust.

A typical "estate trust" gives the trustee complete discretion to make income or principal distributions while the surviving spouse is alive. The surviving spouse may be denied all income and principal while alive as long as the trust ends on his death and the trust assets are paid over to his estate at that time. An estate trust provides for the withholding of income not currently needed by the survivor and makes possible the reinvestment of it, without the survivor having to pay income taxes. It is not a terminable interest and thus is not required to satisfy either exception to the terminable interest rule. Such a trust qualifies for the marital deduction in the same way as property given outright.(5)

Outright marital distributions and estate trusts were distinguished by the Service from power of appointment trusts and QTIP trusts. The Service held that the estate trust qualified for the marital deduction but the amount of the deduction would have to be reduced by the face amount of all outstanding guaranteed loans and not the present value of all payments that the estate trust could reasonably be expected to bear. The Service would similarly reduce outright marital bequests of property when there were guarantees.

The Service went on to state that if the estate trust is not sufficiently funded with an amount in excess of the face amount of the outstanding guarantees, the second trust would fail to qualify as a QTIP trust under Sec. 2056(b)(7). The IRS's position was that the creditors may have an interest in this second trust in contravention of the requirement that no one other than the surviving spouse have an interest in the trust while the surviving spouse is alive. The violation of the qualifying income interest rule was deemed to cause the entire trust to fail to qualify for the marital deduction.

The impact of contingent liabilities on the marital deduction was the reason the taxpayer attempted to insulate the QTIP trust from potential liability. The taxpayer, however, was held to have underestimated the valuation of those guarantees for marital deduction purposes.

Was the IRS's Ruling Correct

in Light of Existing Authorities?

If the requested ruling had involved a gift subject to a guarantee(6) it is more than likely that the Service, to preserve the tax base, would argue that the value of the gift is reduced by only the present value of the estimated future cost of the liability.

In Guggenheim,(7) the projected discounted cost of a guarantee given by a father on behalf of his son reduced the Federal estate tax value of certain securities. Similarly, in Harrison,(8) the value of a remainder interest in a trust was reduced by the present value of projected payments from principal necessary to pay income and gift taxes of the settlor.

To support its position in the ruling, the Service cited Wycoff,(9) in which a marital deduction was reduced by death taxes that might have been paid from a marital trust, although the taxes were in fact satisfied from other assets.

However, the face amount reduction of a contingent obligation in Wycoff can be distinguished from the guarantee situation involved in the ruling. The amount chargeable against the marital amount in Wycoff was covered by the discretion of the personal representative and not dependent on future contingencies (as is the case with a guarantee). Contingent liabilities are not all the same and must be valued in light of their own facts and circumstances. A case-by-case consideration of the collateral pledged, right to subrogation and net worth of the primary obligor is needed when valuing a guarantee.

* Deductibility of guarantees

After providing for a value reduction of the entire amount of a contingent obligation in determining the marital deduction, the Service said that a guarantee is deductible under Sec. 2053 only to the extent it is actually paid during the administration of the estate, reduced by the value of the claim against the primary obligor. The direct indebtedness incurred by the taxpayer was held to be deductible. A distinction was made between back-to-back loans and guarantees, both gift and personal. The IRS's position on a deduction appears consistent with the existing case law,(10) leaving the taxpayer possibly without a marital deduction for either the estate trust or QTIP trust and not eligible for a deduction under Sec. 2053 for the guarantees.

* Gift consequences of guarantees

The IRS went on to conclude that a gift is made at the time of the execution of a guarantee and a later gift is made if payment is required pursuant to the guarantee. The guarantee is characterized as a "valuable economic right or benefit." The Service reached this conclusion by relying on the Supreme Court's decision in Dickman:(11) The Court held that an interest-free loan to a family member was a transfer of property by gift. The lender was treated as having made a taxable gift of the reasonable value of the use of the money. Citing Dickman, the IRS stated:

The gift tax was designed to encompass all transfers of property and property rights having significant value. The transfer of a valuable economic right or benefit is a property interest that is subject to the gift tax. The valuable economic right is generally readily measurable by reference to current interest rates.

It may be argued that such an extension of Dickman is inconsistent with the measures Congress took in the Tax Reform Act of 1984. Sec. 7872 was designed to be a codification of Dickman and was thought to represent an all-inclusive attempt to stem taxpayer avoidance in this area. Sec. 7872 divides loans with below-market interest rates into gift loans and nongift loans; it then subdivides each category between term and demand loans. All loans that carry a below-market rate or charge no interest at all have imputed interest at the applicable Federal rate (AFR) as determined by the Secretary on a monthly basis. The current AFR is designed to reflect the average yield of outstanding marketable U.S. securities with comparable maturities. Any spread that may exist between the AFR and the rate generally charged by banks or other commercial lenders is not considered a gift, yet is it not "a valuable economic right or benefit"? If the AFR is less than what a commercial lender would charge, is the difference not a "valuable economic right ... generally readily measurable by reference to current interest rates"?

Sec. 7872 could have addressed guarantees but does not. The author believes any such extension should be left to Congress.

The Service has consistently sought to extend Dickman into other areas(12) but has had little success in court.(13)

It could be argued that the mere execution of a guarantee does not constitute a gift because the guarantor at that point has not parted with the dominion and control over any asset(14) or because such a gift cannot be valued currently. Alternatively, the execution of a guarantee may be only a promise to make a gift in the future. For example, in Archbold(15) a promise to make contributions of $10,000 annually for a specified term to a trust was held to be only a promise to make future gifts, not a present gift, even if the promise was enforceable.

Marital Deduction Planning

After Letter Ruling 9113009

Marital deduction planning after the ruling should take on a more rigid view of loan guarantees. One lesson to be learned might be that both power of appointment trusts and QTIP trusts should be completely insulated from any potential liability for loan guarantees made by a decedent. When an estate consists of a marital deduction portion and a taxable portion, the applicable will or inter vivos trust agreement might provide that all guarantee payments are to be made exclusively from the taxable portion. When an estate consists of an outright marital bequest or estate trust and either a power of appointment trust or QTIP trust, it might be better for the applicable will or inter vivos trust agreement to provide that all guarantee payments are to be made exclusively from the outright marital bequest or estate trust. Further, depending on the case, the taxable portion, outright marital bequest or estate trust should not be funded with less than the face amount of all outstanding guaranteed loans if a power of appointment trust or QTIP trust is to qualify for the marital deduction.

An admittedly extreme solution may be to advise all clients to avoid guarantees entirely and instead rely on back-to-back loans. The Service placed a great deal of significance on the distinction between the two in the ruling.

In the context of a family, a parent might borrow funds directly and reloan the proceeds to a child in return for an installment note that is canceled at the death of the parent ("self-destructing installment note"). There is generally no estate inclusion since the parent has no interest in the note after his death.(16) Yet Letter Ruling 9113009 seems to indicate that the parent's estate may deduct the direct indebtedness due from the estate. The Service will recognize the validity of installment notes that are canceled on death if the payout period is less than the life expectancy of the parent.(17)

The cancellation feature must be contained in the note itself and not in the parent's will or trust agreement. To avoid any possible gift implications, the interest rate should be at least equal to the AFR at the date of the note, adjusted for a mortality contingency after each payment. IRS Table 80CNSMT(18) is the underlying mortality table used to calculate factors involving life contingencies in accordance with Sec. 7520; it is applicable to gifts made after Apr. 30, 1989 and to estates of decedents dying after that date.

Example: Parent, P, age 55, borrows $10,000 and lends the funds to his child, C. The loan from P to C takes the form of a self-destructing installment note. The note provides for the annual payment of interest and the payment of the principal amount in a lump sum after 10 years. The appropriate AFR is 8%. The interest rate for the first year would be 8%, as the probability of not receiving payment is zero. The next year the interest rate would be weighted for the probability of an individual age 55 dying before reaching age 56. The table amount for age 56 (87551) is divided by the table amount for age 55 (88348) and then subtracted from one (0.009). This represents the probability that P will not survive to receive that payment. The result is added to one (1.009) and multiplied by the AFR for a new interest rate of 8.07%. The interest rate so determined for each payment period is multiplied by the outstanding principal amount of $10,000.

The IRS's attempts to attach income tax consequences to self-destructing installment notes have met with only limited success. An argument could be made that no gain is reported because there is no "disposition" of the note as the cancellation was a bargained for consideration. The Service, however, has alternatively argued that the estate must recognize unreported gain on the initial fiduciary income tax return(19) or that unreported gain must be reported on the final income tax return of the decedent. The Tax Court recently rejected the first alternative argument but adopted the second.(20)

If the unreported gain is reported on the final income tax return of the parent, the income tax liability may be deducted on the Federal estate tax return. Assuming the estate is in a 50% estate tax bracket and the parent is in a 31% income tax bracket, the income tax liability reduces the taxable estate for a net tax cost of 151/2%. The beneficiaries of the estate benefit by the difference between the estate tax rate and the net tax cost, or 341/2%.

The child, as obligor on such a self-destructing installment note, does not recognize discharge of indebtedness income. The cancellation on the death of the parent has been held a cancellation of a contingent obligation that does not produce income.(21)

Conclusion

There has been a great deal of debate among tax practitioners over the IRS's denial in Letter Ruling 9113009 of a marital deduction when QTIPs and guarantees are involved. A reconsideration of the ruling by the Service and the Treasury Department is listed on the current business plan of the Assistant Secretary of the Treasury. As of the date this article goes to press, the best information is that when reconsidered, the ruling will be limited to the valuation and gift tax issues indicated herein and there will not be the impact on the marital deduction, especially QTIP, that the ruling now proposes.

Strictly speaking, a letter ruling cannot be applied to any taxpayer other than the one who requested it.(22) Many tax practitioners are not changing their existing estate plans based on the ruling. It is their opinion that if the ruling is ever litigated in the courts, it will fail, at least on the marital deduction issues. These same tax practitioners maintain that the risk that the ruling will become permanent, or be applied as now written, is remote.

This author does not suggest that taxpayers make radical changes to their existing estate planning practices until the Service issues something more authoritative to reinforce its policy, or the matter is litigated and a court decision is rendered. However, a letter ruling is a written determination of the Service relative to its position concerning the tax treatment of a prospective transaction. As such, it is important that a tax practitioner be aware of this ruling and have a knowledge of the possible alternative traditional solutions available.

Abbreviations Commonly Used in The Tax Adviser

TTA          The Tax Adviser
AFTR2d       American Federal Tax Reports,
             second series (Prentice-Hall)
Ann.         IRS Announcement
CB           Cumulative Bulletin
Cir.         Court of Appeals
Cl. Ct.      Claims Court
COBRA        Consolidated Omnibus Budget
             Reconciliation Act of 1985
Cong. Rec.   Congressional Record
DC           District Court
DRA          Deficit Reduction Act of 1984
ERISA        Employee Retirement Income
             Security Act of 1974
ERTA         Economic Recovery Tax Act of 1981
Fed. Reg.    Federal Register
F2d          Federal Reports, second series
F Supp       Federal Supplement
GCM          General Counsel's Memorandum
H. Rep.      House Ways and Means
             Committee Report
IR           Internal Revenue News Release
IRB          Internal Revenue Bulletin
LTR          IRS Letter Ruling
PL           Public Law
Regs. Sec.   Treasury Regulation
Rev. Proc.   Revenue Procedure
Rev. Rul.    Revenue Ruling
RRA          Revenue Reconciliation Act of 1990
Sec.         Section (refers to the Internal
             Revenue Code of 1986 unless
             otherwise indicated)
S. Rep.      Senate Finance Committee Report
SSRA         Subchapter S Revision Act of 1982
Sup. Ct.     Supreme Court
TAM          Technical Advice Memorandum
TAMRA        Technical and Miscellaneous
             Revenue Act of 1988
TC           Tax Court (regular decision)
TC MEMO      Tax Court (memorandum decision)
TD           Treasury Decision
TEFRA        Tax Equity and Fiscal
             Responsibility Act of 1982
TRA          Tax Reform Act of 1986
USTC         United States Tax Cases
             (Commerce Clearing House)

(1) Sec. 2056(a) and (b)(1). (2) Regs. Sec. 20.2056(b)-1(b) and (c)(1). (3) IRS Letter Ruling 9113009 (12/21/90). (4) Est. of John D. Manscill, 98 TC 413 (1992). (5) Rev. Rul. 68-554, 1968-2 CB 412. (6) See Sec. 2056(b)(4)(B). (7) Florence Guggenheim (executrix), 117 F2d 469 (2d Cir. 1941)(26 AFTR 428, 41-1 USTC [paragraph] 10,022). (8) Sarah Helen Harrison, 17 TC 1350 (1952). (9) Est. of Milton S. Wycoff, 506 F2d 1144 (10th Cir. 1974)(35 AFTR2d 75-1557, 74-2 USTC [paragraph] 13,037). (10) Sec. 2053; Samuel H. Wragg (admin.), 141 F2d 638 (1st Cir. 1944)(32 AFTR 453, 44-1 USTC [paragraph] 10,098); Rev. Rul. 84-42, 1984-1 CB 194. (11) Esther C. Dickman, 465 US 330 (1984)(53 AFTR2d 84-1608, 84-1 USTC [paragraph] 9240). (12) IRS Letter Rulings (TAMs) 8723007 (2/18/87) and 8726005 (3/13/87). (13) See Elizabeth W. Snyder, 93 TC 529 (1989). (14) Eleanor A. Bradford, 34 TC 1059 (1960). (15) John D. Archbold, 42 BTA 453 (1940). (16) Ruby Louise Cain, 37 TC 185 (1961), acq. 1962-2 CB 4; Est. of John A. Moss, 74 TC 1239 (1980), acq. in result, 1981-1 CB 2. (17) GCM 39503 (6/28/85). (18) Notice 89-60, 1989-1 CB 700; IRS Publication 1457 (8/89), Actuarial Values-Alpha Volume. (19) Rev. Rul. 86-72, 1986-1 CB 253. (2O) Est. of Robert E. Frane, 98 TC 341 (1992). (21) Corporacion de Ventas de Salitre y Yoda de Chile, 130 F2d 141 (2d Cir. 1942)(29 AFTR 1074, 42-2 USTC [paragraph] 9599). (22) Sec. 61 10(j)(3).