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Recent developments in QPRTs and QTIPs.

Two methods by which property can be transferred within a family to minimize estate taxes are use of a qualified personal residence trust or a qualified terminable interest property trust. This article discusses recent court decisions and rulings in each area and suggests why future planning strategies using either of these methods may have to be modified.

Recent developments in gift and estate taxation have clarified some of the rules governing qualified personal residence trusts (QPRTs) and qualified terminable interest property (QTIP) trusts. These developments dictate that new strategies be applied to intrafamily transfers of interests in property.

QPRTs

Individuals with assets exceeding $675,000 or married couples with assets exceeding $1.35 million need planning beyond annual exclusion gifts and life insurance trusts. A QPRT can be a valuable estate planning tool for clients who own a residence. It allows one to part with ownership of the residence, but not lose control over it, for an extended period of time. As is discussed later, the definition of "residence" has been liberally interpreted recently to include large recreational areas and certain rental properties.

However, the advantages of QPRTs are conditioned on relinquishing ownership (if not use) of the residence. Many clients will not part with ownership of a residence (or for that matter, any other asset) during life. In such case, can the taxes ultimately due on the second death of a married couple be minimized? One answer might be to separate assets otherwise passing to a surviving spouse on death into assets conveyed outright to that spouse and assets conveyed to a QTIP trust for that spouse's benefit. As will be discussed, recent authority would allow a fractional interest discount for the assets owned outright by the surviving spouse at death.

Example: H owns 100% of the stock of XYZ Corp. At his death, he leaves 49% of that stock outright to his wife, W, and 51% of it to a QTIP trust for her benefit. The executor of H's estate claims a marital deduction for the full value of the XYZ stock; thus, H's estate pays no estate tax. On W's subsequent death, her executor includes in her estate both the stock she received outright, as well as the entire value of the QTIP trust, but claims a 40% fractional interest discount for the stock she owned outright at death.

Is this a permissible method for creating a valuation discount on the surviving spouse's death? As confirmed by recent court decisions (discussed below), the answer appears to be "yes," but that is not the IRS's position.

In determining the value of a gift of an interest in property, the property's fair market value (FMV) is generally reduced by the FMV of any interest retained by the transferor.(1) The burden of establishing the value of the retained interest is on the transferor.(2) Generally, the transferor would use actuarial principles and Federally determined interest rates (under Sec. 7520) to meet that burden. However, normal valuation rules typically do not apply to intrafamily transfers; Sec. 2702(a)(2)(A) generally values any retained interests at zero, effectively increasing the value of the conveyed interest. However, if the transfer is of an interest in trust, all the property in which is a residence used as a principal residence by the term interest holders, Sec. 2702(a)(3)(A)(ii) provides that Sec. 2702(a) does not apply; the normal Sec. 7520 valuation rules apply.

Regs. Sec. 25.2702-5(b) and (c) provide for two types of personal residence trusts; the QPRT is the more flexible and commonly used. In a QPRT, a person generally transfers a remainder interest in a personal residence in trust to a family member and retains use of the property for a term of years.

Use of a QPRT is a way of leveraging the unified credit and removing all future appreciation from the estate. By delaying when the residence will pass to the ultimate beneficiaries, the value of the gift can be discounted for gift tax purposes. However, if the grantor does not survive the trust term, the entire trust value is included in the estate and the unified credit is restored. During the trust term, the trust is normally structured as a grantor trust; the grantor is entitled to the income tax deductions for real estate taxes and mortgage interest he had before the transfer of the property to the trust.

Defining "Personal Residence"

The term "personal residence" is defined by Regs. Sec. 25.27025(c) (2)(i)(A) and (B) to include the term holder's principal residence or one other residence as defined in Sec. 280A(d)(1) (or an undivided fractional interest in either). A personal residence includes a houseboat, house trailer, stock in a cooperative housing corporation,(3) appurtenant structures used for residential purposes (e.g., a garage) and adjacent land not in excess of that reasonably appropriate for residential purposes (taking into account the residence's size and location).(4)

Cooperative apartment: In Letter Ruling 9925027,(5) a taxpayer intended to transfer legal title to her shares and proprietary leases in a cooperative housing corporation to a QPRT, but the cooperative association disapproved the taxpayer's request. The taxpayer then transferred beneficial title to the shares and leases to the trust and continued to hold the legal title as nominee. The ruling held that the trust qualified as a QPRT.

Surrounding property: A number of recent decisions have addressed whether large surrounding property will be included as part of a personal residence.

In Letter Ruling 9841015,(6) the property consisted of a residence, two barns and a wood and tool shed. The residence was used solely as a single-family home for a number of years; no commercial activity was conducted on the property. A number of residential properties nearby contained similar acreage. The residence, with the extra acreage, was held to be a personal residence.

In Letter Ruling 9918042,(7) a personal residence contained wooded property used as a large recreational area. A local ordinance prevented its subdivision; use of the area was non-commercial. The ruling concluded that the property was a personal residence.

In Letter Ruling 9918049,(8) a personal residence was held to include a tennis cottage, caretaker's house and adjacent land. Again, the focus was on the locality and whether the residence was reasonable for it.

Rental property: There is a general prohibition on rental property being transferred to a QPRT. According to Regs. Sec. 25.2702-5(c)(2)(iii), a residence is not used primarily as a residence if it is used to provide transient lodging and substantial services are provided in connection therewith. If the residence is not the term holder's principal residence, it will be treated as his residence (within the meaning of Sec. 280A(d)(1)) if he uses it (or a portion of it) for personal purposes for the greater of 14 days or 10% of the number of days during the year the unit is rented.(9)

The issue of rental property qualifying as a personal residence has been addressed in two recent rulings. In Letter Ruling 9906014,(10) a vacation residence that included a separate apartment rented to unrelated individuals qualified as a personal residence. The rental was held to be incidental to the property's use as a residence. At the end of the income term, the trust property was to pass to a family trust for the spouse's lifetime benefit, if the spouse was married to the donor at the latter's death. Under the family trust, the spouse was entitled to use and occupy the residence for her life. At her death, the remaining trust property was to pass in trust for the benefit of the donor's descendants. An issue was whether the donor retained enjoyment after expiration of the income term under Sec. 2036 or any other Code provision, based on an implied arrangement or understanding that he would continue to live in the residence with his spouse.

Regs. Sec. 25.2702-5(c)(7)(i) provides that a residence is held for use as a personal residence of the term holder so long as the residence is not occupied by any other person (other than the term holder's spouse or dependent). The IRS held that, if the donor survives the income term, he will not be considered to have retained any interest in the transferred property that would subject it to inclusion in his estate under Secs. 2035, 2036, 2037 and 2038. The IRS referred to Rev. Rul. 70-155(11) in concluding that co-occupancy by the donor with the donee, as husband and wife, does not, by itself, support the inference of an agreement or understanding as to retained possession or enjoyment by the donor.

In Letter Ruling 9916030,(12) a QPRT grantor was designated as income beneficiary for the shorter of 20 years or her life, and retained a testamentary general power of appointment if she did not survive the term. It was held that the value of the gift of the contingent remainder interest equaled the market value of the property transferred, minus (1) the present value of the grantor's retained income interest in the property (determined under Sec. 7520) and (2) the present value of the grantor's retained contingent reversion in the property (determined under Sec. 7520). Significantly, it was held that the lease during the trust term of a caretaker residence that was part of the property would not cause it to fail to qualify as a personal residence.

Leasing on Termination

A grantor who is concerned with relinquishing use of the residence at the end of the trust term may consider leasing the property at termination.(13) The grantor could require, as a condition to establishing the trust, that the remainder beneficiary agree to enter into an FMV lease on trust termination. Because a grantor is prohibited by Regs. Sec. 25.2702-5(b)(1) and (c)(9) from purchasing the residence from the trust before the end of the trust term, the ability to lease the residence at the end of the trust term has added significance if the grantor desires continuing control over the trust property following trust termination. Regs. Sec. 25.2702-5(c)(9) generally provides that the governing instrument must prohibit the trust from selling or transferring the residence (directly or indirectly) to the grantor, his spouse or an entity controlled by the grantor or his spouse during the retained term interest or at any time after the retained term interest that the trust is a grantor trust.

The manner in which the designated remainder beneficiaries will receive their interests in the residence may vary; such interests could be inherited outright or held in further trust.

If all the remainder beneficiary interests are held in trust, the residence will be protected from potential divorce, litigation or malpractice claims. In addition, the grantor may experience more security in his ability to negotiate an arm's-length rental of the residence.

The remainder beneficiary can be a trust for the benefit of the grantor's descendents (or for anyone else). The grantor can be the trustee, as long as he does not retain powers or interests that would result in estate inclusion. The trust might be an "intentionally defective grantor mast;" the goal would be to include a mast provision that causes the trust assets to be deemed owned by the grantor for income tax purposes, but not transfer tax purposes. Thus, the grantor might continue to deduct real estate taxes or mortgage interest against his personal income, even after termination of the original QPRT. Although a grantor cannot substitute assets, he might permit a related or subordinate trustee to make discretionary distributions (or permit a nonadverse party the power to add a beneficiary) to reach the desired result.

In Letter Ruling 9918042, an option to lease the property at the end of the term, held by the grantor and his spouse, did not invalidate a QPRT. In Letter Ruling 9829002,(14) a QPRT was established for the earlier of a term of years or the death of the second spouse to die. Capital gains were to be accumulated and added to principal; the grantors had a general testamentary power to appoint the accumulated income. The grantors were deemed to be the owners of the trust principal under Sec. 674(a) and were treated as owning the trust under Sec. 671. The right to rent the property at FMV after the trust term expired would not cause it to be included in either of their estates, under Sec. 2036(a)(1). Further, on the death of the first grantor before expiration of the trust term, any property includible in his estate would pass to the surviving spouse and qualify, if eligible, for the marital deduction.

QTIPs

However valuable an estate planning tool a QPRT might be, it is limited to the value of the personal residence and conditioned on a client's willingness to part with ownership of the residence during his life. QTIP trust planning, on the other hand, does not require that a client part with ownership during life.

Sec. 2056(a) and (b)(1) permit an estate tax marital deduction for property that passes to a surviving spouse and is not a terminable interest. Regs. Sec. 20.2056(b)-1(b) defines a "terminable interest" as one that will terminate or fail on the passage of time or on the occurrence (or failure to occur) of some contingency. However, under Sec. 2056(b)(7), the value of "qualified terminable interest property" that passes from the decedent and in which the surviving spouse has a "qualifying income interest" for life is eligible for the marital deduction. According to Sec. 2056(b)(7)(B)(ii), 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. Under Sec. 2044(b)(1)(A), the value of the QTIP property is included in the surviving spouse's gross estate.

Family corporations and corporations with few shareholders are not the only close corporations. For estate tax valuation purposes, shares of a close corporation are those that are "not listed on any stock exchange, not dealt in actively by brokers, not quoted on a bid and asked price, not sold by the personal representative of decedent, or at private sale, within a reasonable period near decedent's death."(15) The result is that special valuation methods and valuation discounts may be applied to very large corporations not listed on any exchange or otherwise traded regularly. Further, family attribution is not a factor in determining the value of minority interests.(16) Two recent cases have upheld a 40% valuation discount for closely held businesses.(17)

Aggregation

IRS's position: In the two rulings discussed below, the IRS sought to aggregate assets held by a surviving spouse and by a QTIP trust for the surviving spouse's benefit. The IRS's position is that Sec. 2044 contemplates that QTIP property will be treated as passed from the decedent for estate tax purposes; thus, the QTIP assets should merge with other assets owned by the decedent.

In Letter Ruling (TAM) 9550002,(18) a decedent owned 200 shares of stock; another 150 shares of stock in the same corporation were held in a QTIP trust for the decedent under the will of her predeceased spouse. The corporation had a total of 500 shares outstanding. The IRS held that the stock includible in the gross estate under Sec. 2033 and the stock included under Sec. 2044 constituted a single block of stock for purposes of determining whether the stock represented a majority or minority interest. The two blocks of stock were treated as one block for valuation purposes.

Similarly, in Letter Ruling (TAM) 9608001,(19) a decedent owned partnership interests through a revocable trust includible in her estate under Sec. 2038. The decedent also held interests in the same partnership via a QTIP trust for her benefit under the will of her predeceased spouse; such interests were includible in her estate under Sec. 2044. The IRS held that the two interests had to be aggregated for valuation purposes; accordingly, the decedent held a majority interest in the partnership.

Courts' position: The courts, however, have been much more reluctant to aggregate assets held by a surviving spouse and by a QTIP trust for that spouse's benefit.

In Est. of Bonner,(20) the decedent died owning a 62.5% undivided interest in Texas real estate and 50% undivided interests in New Mexico real estate and a yacht. The remaining interests in each asset were owned by a QTIP mast established by the decedent's predeceased wife. The FMVs of entire properties were not in dispute. The QTIP interests were includible in the husband's estate under Sec. 2044; interests owned by him outright were includible under Sec. 2033. The decedent's estate claimed a 45% fractional interest discount for the undivided interests owned outright by the decedent at death.

The Fifth Circuit held that public policy mitigated in favor of the estate's position. Because the predeceased spouse's estate controlled the disposition of her assets, the assets had to be taxed as if they were controlled by her, meriting a fractional interest discount. In addition, because the surviving spouse did not have control over the predeceased spouse's assets, he would be at a disadvantage in negotiation with any willing buyer. Although this case does not involve stock, under the approach taken therein, it is clear that direct and indirect ownership interests (via an interest in a QTIP trust) would not be combined into a single block of stock.

In Est. of Mellinger,(21) a block of publicly traded stock held in a revocable trust and includible in a decedent's estate was not merged for valuation purposes with additional shares held in a QTIP trust includible in her estate. Before his death, the decedent's husband had placed his 27.9% stock interest in Frederick's of Hollywood, Inc. (which he founded) into a QTIP mast for the decedent's benefit. Before her death, the decedent contributed her 27.9% of Frederick's stock to a revocable trust. The estate applied a 31% blockage discount to the value of the stock in each trust, resulting in the value of $4.79 per share. Approximately four years after the decedent's death, the stock was sold for $6.90 per share under a merger agreement. Following Bonner, the Tax Court concluded that, for estate tax purposes, the decedent was not the owner of the QTIP stock. Nevertheless, the court allowed only a 25% marketability discount, citing weaknesses in the estate's appraisal method.

Similarly, in Est. of Nowell,(22) minority partnership interests held in a revocable trust were not aggregated for valuation purposes with similar interests held in a QTIP trust. The Tax Court followed its reasoning in Mellinger, concluding that the decedent should not be treated as the owner for QTIP valuation purposes. The partnership interests were eligible for lack of marketability and lack of control discounts.

Finally, in Est. of Lopes,(23) the Tax Court again followed Bonnet and Mellinger. For valuation purposes, a decedent's undivided interests in certain real properties held in trust were not aggregated with similar interests held in a QTIP trust. The estate was allowed to discount the fractional interest held in each trust for marketability and minority interests.

The foregoing court decisions provide authority for not aggregating QTIP interests with other interests for estate tax valuation purposes. A tax adviser should consider creating discount opportunities for an estate of a surviving spouse by providing on the death of the first spouse for an undivided interest in property to pass outright to the surviving spouse and any remaining interest to pass to a QTIP trust for the surviving spouse's benefit. Further, refund claims may be fried for estates based on fractional interest discounts if the facts are similar to those in Bonner.

Disclaimers

If the estate of a surviving spouse is able to successfully argue that it is entitled to a fractional interest discount for properties held outright at death while the statute of limitations is open on the predeceased spouse's estate tax return, might the IRS argue that the marital deduction claimed on the predeceased spouse's estate tax return must be similarly reduced, resulting in a tax on that estate?

This concern stems from a recent decision involving a qualified disclaimer and its effect on the marital deduction. In Est. of DiSanto,(24) a decedent owned a controlling interest in a fabric processing corporation. He left the residue of his estate, including the stock, to a trust for the benefit of his wife and children. The wife disclaimed part of her interest in his estate and, thus, received only a minority block of stock. She died before administration of her husband's estate was completed. The issue was the size of the marital deduction in the husband's estate; should it be based on the actual stock bequeathed to the wife or the post-disclaimer amount? The value of the stock in the husband's estate was reported at $25.80 per share; the estate tax return claimed a marital deduction for the post-disclaimer number of shares at $25.80 per share. The IRS argued that the deduction should have taken at $12.16 per share.

The Tax Court valued the stock at $23.50 per share for purposes of inclusion in the husband's estate, but at $13 per share for marital deduction purposes, because, after the disclaimer, the wife held only a minority block. The court held that a change from a controlling interest to a minority interest is not a post-death fluctuation in the value of stock that can be disregarded in deciding the marital deduction.

There would appear to be no definitive answer to the marital deduction question in the context of a QTIP trust. As with other areas of the tax law, further developments are bound to occur.

EXECUTIVE SUMMARY

* Recent decisions have not aggregated QTIP interests with similar interests bequeathed outright to a surviving spouse, and have allowed fractional interest discounts.

* Use of a QPRT is a way of leveraging the unified credit and removing all future appreciation from an estate.

* However valuable an estate planning tool a QPRT might be, it is limited to the value of the personal residence and conditioned on willingness to part with ownership of a residence during life; QTIP trust planning does not require parting with ownership during life.

(1) See Hurlbut W. Smith, 318 US 176 (1943); Regs. Sec. 25.2511-1(e); Sec. 7520.

(2) See Meta B. Robinette, 318 US 184 (1943)

(3) See Kegs. Sec. 1.1034-1(c)(3)(i); IRS Letter Ruling 9448035 (12/2/94).

(4) See Regs. Sec. 25.2702-5(c)(2)(ii) and (d), Example 3.

(5) IRS Letter Ruling 9925027 (6/28/99).

(6) IRS Letter Ruling 9841015 (10/9/98).

(7) IRS Letter Ruling 9918042 (5/10/99).

(8) IRS Letter Ruling 9918049 (5/10/99).

(9) See Regs. Sec. 25.2702-5(c)(2)(i)(B) and (d), Example 2.

(10) IRS Letter Ruling 9906014 (2/26/99).

(11) Rev. Rul. 70-155, 1970-1 CB 189.

(12) IRS Letter Ruling 9916030 (4/26/99).

(13) See IRS Letter Ruling 9448035, note 3 supra.

(14) IRS Letter Ruling 9829002 (7/17/98).

(15) See Edward Brooks, 78 F2d 270 (8th Cir. 1935).

(16) Rev. Rul. 93-12, 1993-1 CB 202.

(17) See Est. of Richard R. Simplot, 112 TC 130 (1999); Est. of Ann H. Brookshire, TC Memo -1998-365.

(18) IRS Letter Ruling (TAM) 9550002 (12/15/95).

(19) IRS Letter Ruling (TAM) 9608001 (2/23/96).

(20) Est. of Louis F. Bonner, Sr., 84 F3d 196 (5th Cir. 1996).

(21) Est. of Harriett R. Mellinger, 112 TC 26 (1999).

(22) Est. of Ethel S. Nowell, TC Memo 1999-15.

(23) Est. of Ambrosina Blanche Lopes, TC Memo 1999-225.

(24) Est. of Frank M. DiSanto, TC Memo 1999-421.

For more information about this article, contact Prof. Easton at (908) 879-5563.

Reed W. Easton, J.D., LL.M., CPA Associate Professor Department of Accounting and Taxation Seton Hall University South Orange, NJ
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Title Annotation:qualified personal residence and qualified terminable interest property trusts
Author:Easton, Reed W.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jun 1, 2000
Words:4046
Previous Article:U.S. estate tax exposure for foreign nationals.
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