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IRS loses estate tax marital deduction case.

In Est. of Spencer, 1995, rev'g TC Memo 1992-579, the Sixth Circuit allowed a marital deduction for a qualified terminable interest property (QTIP) trust in which the executor had discretion as to the amount to be placed in it. The IRS and the Tax Court have disallowed a deduction under these circumstances, but all three Courts of Appeals that have considered the issue have ruled against the taxpayers.

In 1981, Congress added Sec. 2056 (b) (7) to the Code to allow a decedent to provide for a surviving spouse while controlling the ultimate disposition of his property. Prior to the change, a decedent either had to leave assets to a spouse outright, or give the spouse a life estate combined with a general power of appointment, in order to obtain a marital deduction. The 1981 change created "qualified terminable interest property." QTIP qualifies for the marital deduction if and to the extent that the decedent's executor elects. Property covered by an election is included in the surviving spouse's estate.

To constitute QTIP, the property must pass from the decedent, and the spouse must have a "qualifying income interest for life." To satisfy this last requirement, the spouse must be entitled to all the income from the property, payable at least annually, and no person can have a power to appoint any part of the property to anyone else.

The QTIP provision, in theory, allows a decedent to give an executor discretion as to the amount to claim as a marital deduction, thereby reducing taxes at the death of the first spouse. This allows the executor to attempt to minimize the combined estate tax burdens on both the decedent and the spouse. However, the IRS has interpreted the rules very strictly, and has reduced the actual amount of discretion a decedent can provide.

The situation at issue involves a will that allows the executor to elect any amount as QTIP. Such a provision is important when the minimum combined estate taxes result if the estates of the spouses are equalized, but property is not owned equally. Allowing the executor to pay some tax on the first estate to reduce taxes on the second can be a valuable planning tool.

The Service's position, reflected in Regs. Sec. 20.2056(b)-7(h), Example 6, is that no part of a bequest in trust will qualify for the marital deduction if the executor has discretion to elect any amount to qualify for QTIP treatment, with the balance going to a non-QTIP trust. The executor's discretion results in no amount of property guaranteed to pass to the spouse. The result in Example 6 contrasts with Regs. Sec. 20.2056(b)-7(h), Example 7. In this example, the executor is directed to elect QTIP treatment for an amount necessary to reduce the decedent's estate tax to zero. While the ultimate marital deduction depends on the proper election and the valuation of the decedent's assets, the example holds that the amount of the bequest is calculable, and therefore qualifies for QTIP treatment.

The IRS has defended its interpretation of Sec. 2056(b) (7) often, and the Tax Court has consistently sided with the Service in not allowing QTIP treatment for an amount limited only by the executor's discretion. The appellate courts have not seen the issue in the same light. In Est. of Clayton, 976 F2d 1486 (5th Cir. 1992), rev'g 97 TC 327 (1991), the surviving spouse was the executor charged with making the QTIP election. Any amount not elected as QTIP would pass to another trust that did not qualify. The IRS and Tax Court held that the discretionary election was tantamount to giving the executor a power to appoint property to someone other than the spouse. Thus, there was no qualifying income interest. The Fifth Circuit, in a strong opinion, rejected this argument as violating the clear purpose of Congress in enacting the QTIP provisions, and allowed the deduction for the amount elected by the executor.

The Eighth Circuit was the next to act. In Est. of Robertson, 15 F3d 779 (8th Cir. 1994), rev'g 98 TC 678 (1992), with facts similar to Clayton, the co-executors (one of whom was the spouse) had discretion to determine the amount to elect, with the balance going into nonqualifying trusts. This court also rejected the IRS's power of appointment argument.

The Spencer case is the latest to deal with the issue. In Spencer, the surviving spouse was the executor. She had discretion to elect the amount going into Trusta (the QTIP trust). The balance of the estate went to Trust B, a nonqualifying trust. A nonbinding statement in the decedent's will indicated that the executor was expected to minimize estate taxes. The Tax Court held that Trust A was not eligible for QTIP treatment because the executor had a power of appointment and, in its view, the property did not pass from the decedent to his spouse. The Sixth Circuit reversed, holding that the date for determining whether a power of appointment exists is the date of electing QTIP treatment. At that point, there clearly was no discretion in funding the trust, so there was no power in anyone to appoint property to anyone but the spouse. The court also held that the specific language of Sec. 2056(b) (7) (A), which allows the marital deduction for QTIP, clearly states that the property is treated as passing from the decedent to the spouse. Therefore, no further analysis was needed.

Individuals whose wills contain discretionary QTIP clauses need to review their estates to determine whether any problems exist. The IRS will presumably continue to challenge QTIP elections in situations similar to these three cases. The regulations were adopted in 1994 after the Clayton reversal, but before the Robertson and Spencer reversals. Unless the clients live in the Fifth, Sixth or Eighth Circuit, there is no authority for making the election; however, the trend of the cases seems clear. If an executor does

make an election under a discretionary clause and claims a marital deduction, the estate tax return should include Form 8275-R, Regulation Disclosure Statement, to disclose the position contrary to regulations, in order to avoid penalties under Sec. 6662.
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Author:Berger, Harvey J.
Publication:The Tax Adviser
Date:Feb 1, 1996
Words:1034
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