IRS loses estate tax marital deduction case.

• Author: Berger, Harvey J.

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...