Printer Friendly

Trap for the unwary: funding QTIP with closely held stock.

Prior to 1982, a transfer of a terminable interest (e.g., life estate or term for years) to a surviving spouse did not qualify for the estate tax marital deduction. For transfers of decedents dying after 1981, and as an adjunct to the creation of the unlimited marital deduction, Congress enacted Sec. 2056(b)(7), which provides a marital deduction for a transfer to a surviving spouse of a terminable interest in property that does not give the surviving spouse testamentary control over the property. The property transferred is termed qualifying terminable interest property (QTIP), and must meet four requirements to qualify for the marital deduction: (1) the property has to pass from the decedent to the surviving spouse; (2) the surviving spouse must be entitled to a qualifying income interest for life"; (3) no other beneficiary can have any rights in the property during the surviving spouse's life; and (4) an irrevocable election must be made on the decedent's tax return to treat the interest as QTIP property.

Sec. 2056(b)(7)(B)(ii) defines a "qualifying income interest for life" as one in which the surviving spouse is entitled to the income from all of the property, payable annually or more frequently, and no person, including the spouse, has any power to appoint any part of the property to anyone other than to the surviving spouse. Furthermore, if the property is unproductive, the spouse must be given the power to require the property to be sold or converted into productive property within a reasonable period of time (Regs. Sec. 20.2056(b)-5(f)(4)). If these provisions are complied with, the property will be treated as passing to the surviving spouse and its full value will be deductible from the decedent's gross estate; the value of the property on the surviving spouse's death will then be subject to tax in the spouse's estate.

Because of the significant estate tax deferral provided, QTIPs play an integral role in estate planning. Care must be taken, however to ensure that QTIP treatment is elected only when all of the QTIP requirements have been satisfied, since an invalid QTIP election can be quite costly to the decedent's beneficiaries. A recent technical advice memorandum illustrates how easy it is to fail the requirements for making a valid QTIP election when the QTIP trust has been funded with the decedent's interest in a closely held corporation.

In IRS Letter Ruling (TAM) 9139001, the decedent was the sole shareholder of his closely held corporation. He died in 1988 and was survived by his spouse and his only son. His will provided that his entire stock interest in the corporation was to be distributed to a trust. Under the terms of his will, the net income of the trust was to be paid at least annually to the spouse and, if the son survived the spouse, the assets of the trust were to be distributed outright to the son on the spouse's, death. The will also provided that the stock could not be sold by the trust (except, as explained below to the son). As long as the son continued in the active management of the company, the son retained the right to vote all of the company's stock. Further, when the son was unwilling or unable to continue in the active management of the company, the trustee was required to offer to sell the stock to the son (or the son's widow) for cash, at a price based on the company's book value. At the time of the decedent's death, the book value of the stock was approximately 80% of the stock's fair market value (FMV); the facts indicated that it was likely that the book value of the stock would always be less than the stock's FMV. Finally, although historically the company had been profitable, it had paid no dividends for several years.

According to the IRS, the visions of the will allowed the son to control not only the earning power of the company by virtue of his his management of the company, but also the payment of dividends to the trust. Historically, the company had a history of never paying dividends; the son's interest in the trust corpus provided him with an incentive to continue having the company not pay dividends; and neither the trustee nor the surviving spouse could cause the company to pay dividends.

In a similar vein, because of his voting control of the company, the son had the power to accumulate dividends, thereby increasing the company's value. The son also could require the trust to sell the company's stock to the son at its book value. Since the company's FMV was greater than the book value, the son, in effect, had the right to acquire the stock in a bargain purchase. Moreover, from the trust's standpoint, the property was effectively nonincome-producing, since the trustee was not only unable to require the company to make distributions to the surviving spouse, but was also precluded from selling the stock without' the son's approval.

The Service determined that the bequest of the company's stock to the trust would not qualify for the marital deduction. First, the son had the power to appoint trust corpus to a person other than the surviving spouse (i.e., himself). Because the stock's book value was less than its FMV at the decedent's date of death (and was expected to remain that way throughout the surviving spouse's lifetime), the IRS concluded that the son's right to make a bargain purchase of the stock effectively permitted the son to substantially deplete the value of the trust corpus; this right was tantamount to a power to appoint property to a person other than the surviving spouse.

Second, the surviving spouse did not have a right to the income from all or a specified portion of the trust property, since she did not have a legally enforceable right to any income from the stock. The Service also noted that since the amount remaining in the trust after the purchase of the stock by the son would not be ascertainable, the spouse's right to income was not a right to income from a specific sum that would be determinable at the time of the decedent's death. The IRS concluded that the bequest did not satisfy the QTIP requirements for the marital deduction and, therefore, the value of the stock was taxable in the decedent's gross estate.

Although the book value purchase option in the letter ruling was granted by the terms of the decedent's will, it is not unusual to fund marital trusts with closely held stock subject to a buy/sell agreement. The option price granted in a buy/sell agreement frequently will provide for a price that is less than FMV. Consequently, estate planners should be on the alert whenever stock subject to a buy/sell agreement is used to fund a QTIP trust if the option purchase price may be less than the stock's FMV. If that is the case, the QTIP election could be invalidated with respect to the entire trust corpus (which in the case of closely held stock could constitute a substantial portion of a decedent's estate.
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:qualifying terminable interest property
Author:Kurtz, N. Patricia
Publication:The Tax Adviser
Date:Dec 1, 1992
Previous Article:Construction contracts: multistate sales and use tax implications.
Next Article:Form 5471 reporting for resident aliens complicated by family attribution rules.

Related Articles
Q-TIP trusts and loss of marital deduction.
Cases and rulings on the marital deduction, and miscellaneous estate and trust issues.
The IRS's general aversion to loan guarantees on QTIP trust planning.
Formula! Formula! Formula!
IRS loses estate tax marital deduction case.
Divided Tax Court now allows estate tax marital deduction for QTIP property contingent on executor's QTIP election for estates of decedents dying...
QTIP cannot escape taxation in both spouses' estates.
... More on Letts.
Using IRAs to fund QTIP trusts.
Marital trusts and the Sec. 754 election.

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters