Did You Just Gift That?

• Citation: Vol. 36-6
• Year: 2025

1

Did You Just Gift That?

No. Vol. 36 Issue 6 Pg. 46

South Carolina Lawyer

May, 2025

FEATURE

BY PHILLIP J. MARTIN

Lawyers should consider themselves lucky when they read a decision, particularly a popular one, and come away feeling that they can safely proceed with business as usual. By the same token, every lawyer can remember reading "that opinion" that required them to rethink how a certain aspect of their practice was going to change moving forward. 2024 was a year in which estate planning attorneys got not one, but two opinions from the Tax Court that, for better or worse, certainly fit into the latter category. This duo of cases, which undoubtedly will be eternally paired together as "Anenberg and McDougall," directly provides clarity on the effects of terminating a Qualified Terminable Interest Property Trust ("QTIP trust"), and also evidence how the IRS seems to be examining the modification of irrevocable trusts.

Statutory Framework

To understand the importance of these cases, it is necessary to provide an explanation of the statutory framework upon which these opinions are based. In general, when an individual dies, the value of their gross estate that exceeds that individual's lifetime estate tax exemption is subject to the estate tax.^[1] However, property that passes to a decedent's surviving spouse, subject to certain restrictions, qualifies for the unlimited marital deduction, which suspends application of the estate tax until the death of the second spouse to die.^[2]There are certain limits on the kinds of interests that qualify for the martial deduction. Section 2056(b) provides that a terminable interest, which is an interest in property that terminates upon the occurrence or non-occurrence of a certain event, ordinarily does not qualify for the marital deduction. In practice, property passing to a trust for a surviving spouse typically does not qualify for the marital deduction as the interest in the property terminates upon the surviving spouse's death. However, Section 2056(b)(7) allows QTIP trusts to qualify for the marital deduction.^[3]

Far from being self-explanatory, Qualified Terminable Interest Property is defined to mean property (i)

which passes from the decedent, (ii) in which the surviving spouse has a qualifying income interest for life, and (iii) to which an election under this paragraph applies.^[4] A "qualifying income interest for life" is where (i) the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property, and (ii) no person has a power to appoint any part of the property to any person other than the surviving spouse.^[5] A trust is said to be "QTIP'able" if it satisfies the foregoing qualifications and is said to have been "QTIP'ed" or to be a QTIP Trust when the election is made to qualify said trust for the marital deduction.

This irrevocable election is made by the deceased spouse's personal representative on their estate tax return (Form 706).^[6] The election must be made on the last estate tax return filed by the personal representative on or before the due date of the return, including extensions or, if a timely return is not filed, the first estate tax return filed by the personal

representative after the due date.^[7]

A QTIP trust is typically established upon a taxpayer's death through their Will or Revocable Trust Agreement. After the surviving spouse dies, absent the use of any available powers of appointment, the remaining assets in the QTIP trust pass to the beneficiaries as set by the grantor-spouse.^[8]

In summary, a QTIP trust allows assets to pass to the grantor's spouse in a trust that qualifies for the marital deduction. One of the primary benefits of doing so is that this reduces the estate tax liability owed at grantor's death, while allowing the grantor to dictate where the assets go upon the death of the surviving spouse. However, assets held in a QTIP trust are included in the gross estate of the surviving spouse upon his/her death.^[9] Thus, a QTIP trust does not eliminate estate tax, but rather defers it. The assurance that assets in the QTIP trust will be subject to taxation at the surviving spouse's death is the basis for this incredible exception. As you might expect, the Internal Revenue Code ("code") includes provisions to dissuade estate planners from taking action to alter this result.

Section 2519 provides that "for purposes of [imposing the gift tax and the estate tax], any disposition of all or part of qualifying income interest for life in any [QTIP] shall be treated as a transfer of all interests in such [QTIP] other than the qualifying income interest." Stated otherwise, Section 2519 results in a deemed transfer by the surviving spouse of all the principal assets held in a QTIP trust, despite the fact that the surviving spouse only disposed of all or a portion of such spouse's income interest in the QTIP trust. To demonstrate the impact of Section 2519, consider the following example:^[10]

Red is married to Kitty. Red dies and his Will establishes a QTIP-able trust for Kitty. Michael, as Personal Representative, makes a valid QTIP election on Red's timely filed estate tax return. Years later, Kitty wants to transfer one-half of her income interest to her son, Eric. Upon such transfer, Kitty will experience the following results: (1) Kitty will have made a gift of one-half of the income interest to Eric, (2) Kitty will be treated as having transferred all interests in the trust other than her remaining income interest, and (3) since Kitty retained fifty percent of the income interest, fifty percent of the trust property will be includible in Kitty's gross estate under Section 2036.^[11]

Prior to the decisions in Anenberg and McDougall, previous case law also indicated that "the termination of the QTIP trusts alone triggered section 2519," and "the termination of a QTIP trust can result in a transfer of a qualifying income interest for purposes of section 2519."^[12]Because of this, estate planners have been very cautious when dealing with certain modifications or terminations of QTIP trusts. Having described the applicable legal landscape, we can now delve into examining two cases and the effects that may have on said landscape.

Anenberg v. Commissioner^[13]

Sally and Alvin Anenberg established a joint revocable trust which was funded with all the stock of a closely held company. When Alvin died in 2008, various assets, including almost half of the stock, passed to multiple trusts ("marital trusts") for which a QTIP election was made. Alvin's children from his prior marriage were the remainder beneficiaries of these trusts. In March 2012, the marital trusts were judicially terminated with the consent of Alvin's children and Sally. Upon termination, all the assets in the marital trusts (including the stock) were distributed to Sally. Five months later, Sally made a gift of a portion of the stock to Alvin's children. One month later, Sally sold most of the remaining stock to Alvin's children and grandchildren in exchange for promissory notes. Sally's 2012 gift tax return reported the gift and the sale. The IRS reviewed the return, and issued a "Notice of Deficiency" on December 1, 2020 (after Sally's death in 2016), asserting that the termination of the marital trusts and subsequent sale constituted a taxable disposition under Section 2519.

The parties agreed that after Alvin's death, Sally owned a qualifying income interest for life in a QTIP trust, but they disagreed on the application of Section 2519 to the 2012 transactions. The IRS argued that Sally disposed of her qualifying income interest for life either (i) when she agreed to the termination of the marital trusts and accepted their assets or (ii) when she sold the stock in exchange for promissory notes. Sally's estate argued that neither transaction was a disposition under Section 2519 because both amount to no more than a permissible conversion of Sally's qualifying income interest for life in the marital trusts into an equivalent interest in other property. Furthermore, even if there was such a disposition, no gift tax is due because Sally did not make a gift; she received full and adequate consideration for the property. The Tax Court ruled in favor of the estate. As to whether 2519 applied when the marital trusts were terminated, the Tax Court held that even assuming there was a transfer of property under Section 2519, the estate is not liable for gift tax because Sally received back the interests in the property that she was treated as holding and transferring under Section 2056(b) (7)(A), and therefore made no gratuitous transfer as required by Section 2501.^[14]Stated otherwise, how could Sally have made a gift when what she was formerly only deemed to hold is now actually held by her? As to whether Section 2519 applied when Sally sold the stock, the Tax Court held that the estate is not liable for gift tax on the sale of the stock in exchange for promissory notes because Section 2519 is completely inapplicable after the termination of the marital trusts, as any future transactions involving the stock would be covered by the ordinary estate and gift tax rules rather than QTIP regime.^[15]

While this was a great victory for the taxpayer, there was one issue that was left unaddressed: whether the remainder beneficiaries made a gift by agreeing to the termination of the marital trusts. Thankfully, we had a very short wait to receive an answer to that question.

McDougall v. Commissioner^[16]

Bruce McDougall was the beneficiary of a QTIP Trust created upon the death of his wife in 2011 ("residuary trust"). Bruce held a testamentary power of appointment that allowed him to appoint the assets to his wife's descendants. Bruce's two children were the default remainder beneficiaries of the residuary trust. In 2016, Bruce and his children signed a nonjudicial agreement providing for the termination of the residuary trust and the distribution of all its assets to Bruce. On the same day, Bruce sold virtually all these assets to other trusts for his children ("trusts") in exchange for promissory notes. Both Bruce and his children filed gift tax returns, claiming no taxable gifts were made. However, the IRS issued a Notice of Deficiency, arguing that the commutation of the residuary trust resulted in taxable gifts under Sections 2519 and

2511. In this case, the IRS provided three arguments against the taxpayers' positions: (i) Bruce should be treated as making a gift to the children under Section 2519, (ii) the transfer of assets to the trusts was a taxable gift and the value of the promissory notes should be included in Bruce's gross estate upon his death, and (iii) the children made a gift of their remainder interest to Bruce by agreeing to the termination of the QTIP trust. As to the first two arguments, the Tax Court relied heavily on the reasoning in Anenberg in rejecting the IRS's argument. The Court found that even assuming there was a transfer of property under Section 2519 when the residuary trust was terminated and distributed to Bruce, that Bruce did not make any gratuitous transfers because Bruce ended up owning the assets previously held in the residuary trust, outright and free of trust. Similarly, the Court also found that the commutation of the residuary trust followed by the sale of assets previously held in the residuary trust in exchange for promissory notes did not result in gifts from

Bruce to the children. However, the third argument is where things get most interesting.

The Court upheld IRS's claim under Section 2511, finding that the children made taxable gifts to Bruce by relinquishing and agreeing to the commutation of their remainder interests in the residuary trust. The Court rejected the family's argument that these transactions left all parties in the same economic position and held that the surrender of the valuable interests without consideration triggers gift tax. The Court had multiple reasonings for this ruling, the most pertinent of which can be summarized as follows:

1. QTIP Fiction - The taxpayers argued that because the residuary trust is treated as being owned by the surviving spouse under the QTIP regime that the children had nothing to give away. This was found to be erroneous for two reasons: (i) the assets are deemed to be included in the surviving spouse's gross estate, which has the same effect of ownership, but does not equate to ownership and (ii) the QTIP rules govern the taxation of assets between a marital couple and do not govern the treatment of such assets as to third parties.

2. No Reciprocal Gifts. The taxpayers argued that Bruce had made a gift under Section 2519 to the children, who had then made an identical gift in return to Bruce. As the Court ruled that no gift had been made under Section 2519, this argument failed.

3. Can't Give What You Don't Own. The taxpayers argued that because Bruce is treated as owning the assets in the residuary trust the children could not add to his taxable estate by transferring to him something he is already deemed to hold. This argument ignores that the children's remainder interests do have real economic value. Had the children given their remainder interests to a third-party, that certainly would have been a gift under Section 2501.

Unfortunately, while the Court in McDougall was clear that the children had made taxable gifts, they did not address the value of their gifts; instead saving that for a later proceeding.

Practical Implications

Estate planning attorneys have a few tried and true methods for modifying irrevocable trusts, including both judicial and non-judicial. The logic in McDougall was not restricted to either judicial or non-judicial means of trust modification. As such, if any action is taken by the remainder beneficiaries that reduces their economic interests in a trust, they have likely made a gift to the extent of that reduction. In addition, while Anenberg and McDougall dealt with the commutation of a QTIP trust that was consented to by the surviving spouse and the remainder beneficiaries, there is no reason to think the logic in McDougall is limited to QTIP trusts. As such, we should proceed as if modifications of any sort that shift economic benefit from one beneficiary to another will be considered a taxable gift. Most concerningly, it is not perfectly clear the degree to which the remainder beneficiaries must go to avoid making a gift when they are involved in a trust modification.^[17] It is still unclear whether it is sufficient for a remainder beneficiary to avoid making a taxable gift by simply withholding their consent to a proposed modification, or if they must seek to stop such modification.

In order to avoid these issues, estate planning attorneys should be proactive in drafting their documents to address the need for changes once a trust becomes irrevocable. One solution is to allow for the appointment of an "independent trustee" who can make distributions not subject to an ascertainable standard without causing adverse tax consequences by doing so. This would include a trustee (i) who is not a beneficiary of the trust, (ii) who has no legal obligation to support any current distributee of such trust, and (iii) who is not a related or subordinate party, within the meaning of Section 672(c) of the code, to any party described above. This allows clients to avoid giving their children too much control over their inheritance, while leaving the door open to the completion of non-standard distributions.

To illustrate, Eric and his wife, Donna, come to you to prepare their estate plan. Having done well in the potted plant business, Eric wants to leave his assets in lifetime trusts for his children, but he also wants each of them to be able to serve as trustee of their own trust. As the children will be deemed to have a general power over their trusts if the distribution standard goes beyond an ascertainable standard such as health, education, maintenance and support, you suggest including a provision that allows an independent trustee to make distributions for any reason. Eric agrees and names Donna's trusted friend, Jackie, as trustee.

Another solution would be to include a trust protector^[18] who could take certain actions to modify the terms of an irrevocable trust without beneficiary involvement. Potential actions that a trust protector could take would be to (i) amend provisions of the trust agreement for tax purposes (i.e. - add general power of appointment to allow for a basis adjustment under Section 1014), (ii) appoint an independent trustee to make "non-standard" distributions, or (iii) add a power of appointment, which includes the powerholder as a permissible appointee, effectively creating a right of withdrawal not included in the original document.

When you are faced with an irrevocable trust that does not include any helpful provisions, there are still a few techniques worth considering. If you are dealing with a QTIP trust, one option to help mitigate any tax consequences associated with Section 2519 is to divide the QTIP trust before the surviving spouse makes a gift. Then, the surviving spouse can relinquish the income interest in one trust, while the other is unaffected. In addition, Anenberg effectively blesses the commutation of a QTIP trust followed by a subsequent sale of assets previously held in a QTIP trust. Another option is to decant or modify the trust to add either an independent trustee or a trust protector who could take any of the actions described above.

While we are still waiting for further guidance on the valuation issue, these cases provide estate planning attorneys with much to think about as they consider drafting and interpreting trusts. If nothing else, these opinions are a definite indication from the IRS that they are paying close attention to any action that alters the economic interests in irrevocable trusts.

Phillip J. Martin is a shareholder at Merline and Meacham, PA. in Greenville. The author would like to express his gratitude to Michelle H.

King for her tremendous assistance.

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Notes:

^[1] See generally I.R.C. § 2001 et seq.

^[2] I.R.C. § 2056.

^[3] I.R.C. § 2056(b)(7).

^[4] I.R.C. § 2056(b)(7)(B)(ii).

^[5] I.R.C. § 2056(b)(7)(B)(ii).

^[6] I.R.C. § 2056(b)(7)(B)(v).

^[7] Treas. Reg. § 20.2056(b)-7(b)(4)(i).

^[8] However, it is possible to establish an inter vivos QTIP trust. In that event, the QTIP election is made on a timely filed Gift Tax Return (Form 709). See I.R.C. § 2523.

^[9] I.R.C. § 2044.

^[10] All names used in examples were randomly chosen. Any similarities to characters in a sitcom are coincidental and do not reflect the author's admiration for such sitcom.

^[11] See Treas. Reg. § 25.2519-1(g), Example 5.

^[12] Estate of Kite v. Comm'r, No. 6772-08 (T.C. Oct. 25, 2013).

^[13] Est. of Anenberg v. Comm'r, No. 856-21, 2024 U.S. Tax Ct. LEXIS 1284 (T.C. May 20, 2024).

^[14] Id. at 114.

^[15] Id. at 123.

^[16] McDougall v. Comm'n, No. 2459-22, 2024 U.S. Tax Ct. LEXIS 2281 (T.C. Sep. 17, 2024).

^[17] In CCA 202352018, the IRS Chief Counsel posits that the modification of an irrevocable grantor trust to allow for income tax reimbursement to the grantor constitutes a gift from the beneficiary and their issue under Section 2511 by virtue of providing their consent to the modification. The CCA stated their position would be the same if beneficiaries had simply failed to object.

^[18] S.C. Code Ann. § 62-7-818.

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