Cases and rulings on the marital deduction, and miscellaneous estate and trust issues.

• Author: Abbin, Byrle M.

Parts I and II of this article, published in September and October 1991, discussed recent court decisions and IRS rulings on insurance, powers of appointment, retained interests, valuation, gift tax, administration expenses and claims, and disclaimers. This third installment covers the marital deduction, and miscellaneous estate and trust issues. The fourth installment, to be published in December, will cover generation skipping, the charitable deduction and income taxation of trusts and estates.

Marital Deduction

Recent developments relating to the marital deduction included the following.

* Various marital clauses were found to be within the ERTA's transition rule. * State law notwithstanding, a terminable interest was created by requiring a spouse to survive estate distribution. * An estate settlement agreement destroyed the marital deduction. * The executors' ability to divert assets by not electing QTIP status destroyed the marital deduction. * The executor's failure to elect QTIP status, on Form 706, Schedule M, destroyed the marital deduction. * The surviving spouse's right to occupy and use a residence qualified as QTIP. * A QTIP trust was not required to pay undistributed income to the surviving spouse's estate. * A testamentary trust with income to the surviving spouse for life and remainder to charity qualified as a QTIP trust. * A postmortem family agreement to shuffle assets destroyed the marital deduction. * A testator's guarantee of third-party loans to his children jeopardized the marital deduction.

* Various marital clauses deemed within transition rule In Levitt,(101) the decendent's marital bequest was described as an amount equal to "the maximum marital deduction allowable for federal estate tax purposes on my death, reduced by the final federal estate tax values of all other property . . ." passing to his spouse. A second clause required the marital bequest to be reduced by an amount, if any, "needed to increase my taxable estate to the largest amount that will not result in a federal estate tax being imposed by reason of my death, after allowing for the unified credit...." The revocable trust agreement containing the above language was executed in June 1975, and amended in March 1978. The decedent died in 1985, making no other amendments or modifications to the trust agreement.

The Tax Court concluded that the above language qualified for the unlimited marital deduction under the transition rule provided by Section 403(e)(3) of the Economic Recovery Tax Act of 1981 (ERTA).

Critique: ERTA Section 403(e)(3) states that if a decedent dies after Dec. 31, 1981, leaving a will providing for the maximum marital deduction allowable by law, such a provision will be interpreted under the law existing before the ERTA, if the instrument was executed before the date which is 30 days after the ERTA's enactment, and no amendment was made after such date specifically referring to the formula marital deduction.

In Levitt, the IRS asserted that the marital bequest was a maximum marital formula expressly within the meaning of the transition rule. The Tax Court, reversing its previous decision in Blair,(102) held for the taxpayer. The court noted that the first half of the marital bequest clause was clearly a maximum marital formula under ERTA Section 403(e), as it defined the surviving spouse's interest expressly in terms of the maximum amount of property qualifying for the marital deduction. However, the formula was significantly modified by the subsequent provision reducing the marital bequest by any unified credit equivalent available at death. The court concluded that the decedent's intent was clearly to minimize federal estate taxes, and not to limit the amount of property passing to the surviving spouse. The Tax Court issued similar decisions in Higgins(103) and Kendall,(104) both presenting facts virtually identical to those in Levitt.

* Requirement that surviving spouse survive distribution creates terminable interest In Heim,(105) the decedent's will left his entire estate to his surviving spouse. However, if the spouse failed to survive distribution of the estate assets, the surviving spouse's children by a prior marriage were designated as alternative legatees. Notwithstanding a California statute expressly limiting the period of distribution to six months (with a view toward preserving the federal marital deduction), the Ninth Circuit held that the marital bequest was terminable and no deduction was allowable.

Critique: Sec. 2056(b)(1) expressly states that certain terminable interests will not qualify for the marital deduction. A terminable interest is one that will terminate if the occurrence or nonoccurrence of an event can cause the property to pass from the decedent to a third party. However, Sec. 2056(b)(3) permits a contingency for the survivor's subsequent death within six months if the death does not in fact occur. All parties agreed that, absent the California statute, the decedent's marital bequest was terminable since the period of distribution could exceed six months and the surviving spouse could die before final distribution.

The taxpayer asserted deductibility based on the California statute, which was expressly designed to bring terminable interests, such as the one found in the decedent's will, within the Sec. 2056(b)(3) exception. The California statute stated that if "an instrument that makes a marital deduction gift includes a condition that the transferor's spouse survive the transferor by a period that exceeds or may exceed six months ... the condition shall be limited to six months as applied to the marital deduction gift." The Ninth Circuit held that the California statute would have saved the marital deduction in Heim had it been evident in the will that the decedent intended that the bequest qualify for the marital deduction. Since no evidence to that effect was found in the will, the deduction was disallowed.

The decision in Heim is extraordinarily restrictive in its interpretation of Sec. 2056 and the California statute. In effect, the Ninth Circuit concluded that the California savings statute applied only to gifts that were intended to qualify for the marital deduction. Further, since the decedent's will did not mention the marital deduction, nor was there evidence that the marital deduction was discussed with the decedent by either his spouse or attorney, there was no evidence that a marital deduction was sought. This result has a distinct element of the absurd. Obviously, the decedent intended primarily to provide for his spouse and this intent was evidenced by his bequest of 100% of his estate to her. Further, if a marital bequest is couched as 100% of an individual's estate, rather than as a formula, there should be no legal or practical requirement to express in the document that the decedent intended the bequest to qualify for the marital deduction. Finally, since the decedent had no issue of his own, it is not unreasonable to assume that his attorney did not go into great particulars concerning the marital deduction thinking that the entire amount would qualify for that deduction.

Planning hints: The result in Heim is unfortunate for two reasons. First, the loss of deduction must be attributed primarily to inadequate drafting of the marital bequest clause. For the past several decades, it has been recognized that the marital deduction can be lost if its ultimate passage is contingent on the surviving spouse living past the period of distribution. This language should not have been included in the will, notwithstanding the savings statute passed by California. Second, despite the drafting error, the authors believe that the Ninth Circuit used tunnel vision when interpreting the application of the California statute to the facts in Heim.

* Estate settlement agreement results in loss of marital deduction In Schroeder,(106) shortly before his death, the decedent transferred marketable securities to a joint stock account, naming his wife as joint tenant. In addition, he amended his will to provide for the distribution of his probate estate to a trust, with income payable to his surviving spouse for her life and the remainder passing to his children. The decedent's two children, by a prior marriage, were unaware of the joint stock account.

At death, considerable tension arose between the surviving spouse and her stepchildren. In order to alleviate this tension, the surviving spouse entered into a formal agreement under which the joint stock account was conveyed to a trust with income payable one quarter to her for life and three quarters to the children. On the surviving spouse's death, the trust property would pass to the children. In addition, the surviving spouse elected a statutory share in the probate estate, and conveyed this share to the trust established under the agreement. The Tenth Circuit held that the marital deduction was not available.

Critique: The decedent's federal estate tax return claimed a marital deduction in an amount equal to the joint stock account and the statutory share. It asserted that the former passed by operation of survivorship law to the surviving spouse and that the latter was deemed to have passed under the statutory election. Neither interest passed under the will.

The IRS asserted that neither interest was ultimately retained by the surviving spouse because of the settlement agreement and, consequently, did not qualify for the marital deduction. This argument was based on Regs. Sec. 20.205(e)-2(d), dealing with settlements under a will contest, as well as general policy considerations.

The Tenth Circuit held that Regs. Sec. 20.2056(e)-2(d) did not apply, since it is expressly limited to bona fide contests of property interests passing under a will. However, it did hold for the IRS on general policy considerations. The court noted that the underlying structure of the marital deduction is a two-tiered mechanism...