The Marital Deduction and Irc Sections 2511, 2519 and 2207a: a Three-headed Hydra

• Jurisdiction: United States,Federal
• Author: By Adam F. Streisand, Esq. and Deborah J. Bross, Esq.
• Publication year: 2008
• Citation: Vol. 14 No. 4

THE MARITAL DEDUCTION AND IRC SECTIONS 2511, 2519 AND 2207A: A THREE-HEADED HYDRA

By Adam F. Streisand, Esq. and Deborah J. Bross, Esq.^*

I. INTRODUCTION1

The estate tax marital deduction in effect defers federal estate taxes on assets distributable to or (in the case of qualifying trusts) for the benefit of the surviving spouse. The deceased spouse's assets provide economic security for the surviving spouse, and estate tax is paid on assets remaining when the surviving spouse dies. That deferral can be lost, however, and potentially ruinous gift taxes immediately imposed, if there is a transfer of even a small part of the surviving spouse's interest in a QTIP trust. Moreover, this can occur even in circumstances where the transfer involves a bona fide, arm's-length transaction, such as the settlement of litigation.

By way of illustration, consider the following commonplace scenario. A surviving spouse is embroiled in litigation with her husband's children from a prior marriage. The children are contesting their father's trust, which was amended to reduce the children's interest in favor of the surviving spouse's heirs. The trust is a QTIP trust. Its value is $1,000,000, of which $400,000 represents the current value of the spouse's income interest. After protracted negotiations, the parties enter into a settlement agreement that requires a payment from the QTIP trust. Though not spelled out in the agreement, because the funds paid to the children are no longer subject to the trust, the surviving spouse has in effect transferred her income interest in the funds to the children. The agreement includes broad releases all around. The surviving spouse is relieved that the case is finally settled, and may even be congratulating herself on its modest cost. She will probably be shocked, however, to learn that the tax treatment is as follows:

• First, under Internal Revenue Code (IRC) section 2511 (Section 2511), the portion of the payment representing the surviving spouse's income interest (in this case, 40 percent of the payment) is subject to gift tax unless supported by adequate consideration (as it probably is, given the arm's-length settlement);
• Second, regardless of the size of the payment, and regardless of whether it was the result of a bona fide, arm's-length transaction, there is deemed to be an immediate taxable gift of the entire remainder interest—all $600,000 ($1,000,000 minus $400,000)—pursuant to IRC section 2519² (Section 2519), which is treated as a net gift in computing the resulting gift tax;
• Third, the tax on the deemed net gift is the responsibility of the surviving spouse, subject to a right of recovery under IRC section 2207A (Section 2207A); and,
• Fourth, if the surviving spouse fails to enforce the right to recover the gift tax payment from the deemed donee (as is the likely result of the releases), there will be a taxable gift of the unrecovered gift tax payment.

In a worst case scenario, a surviving spouse who transfers or relinquishes his or her right to income from a QTIP trust might inadvertently become personally liable for gift tax on virtually the entire trust (both the income and remainder interests), plus gift tax on the gift tax paid on the remainder interest, an amount which could wipe out the spouse's separate estate (or the attorney's malpractice policy).

To provide guidance to practitioners in avoiding disastrous, unintended consequences under Sections 2519, 2511 and 2207A, this article discusses the legislative history and background of the statutes, and the tax treatment of a variety of transactions based upon the available authorities: Treasury regulations, private letter rulings as well as field service advisory memoranda.

II. IRC SECTIONS 2519, 2511 AND 2207A

A. Legislative History and Background

The estate tax marital deduction of IRC section 2056(a) was enacted pursuant to a policy that spouses should be treated as a single economic unit. To further that policy, Congress determined that no estate tax should arise from a transfer of wealth at the first spouse's death to the surviving spouse.³ Rather, the estate tax is imposed only when a decedent's assets pass to or for the benefit of someone other than the surviving spouse. In a typical estate plan for spouses, assets pass to other beneficiaries only after the surviving spouse's death. Therefore, the estate tax marital deduction in effect defers the estate tax from the first spouse's death to the survivor's death.

As originally proposed in the Senate, the legislation contemplated a marital deduction only for outright transfers to the surviving spouse. In introducing Senate Floor Amendment No. 267, then-Senator Steven Symms explained the Hobson's choice that could create: wife might wish to take advantage of the marital deduction by leaving her assets to husband, but wife might not wish to give complete control of those assets to her husband, particularly if wife would like her children from a prior marriage to ultimately benefit from her assets.⁴

In order to resolve this tension in the originally proposed legislation - section 403(d) of the Economic Recovery Tax Act of1981 (ERTA)⁵ - Congress enacted IRC section 2056(b)(7), which extends the marital deduction to "qualified terminable interest property" (QTIP property). Section 2056(b)(7)(B)(i) defines QTIP property as "property (I) which passes from the decedent, (II) in

[Page 6]

which the surviving spouse has a qualifying income interest for life, and (III) to which an election under the paragraph applies." Under Section 2056(b)(7)(B)(ii), "the surviving spouse has a qualifying income interest for life if: (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."

With respect to QTIP property, Congress enacted IRC section 2044(a), which provides, in pertinent part, that a decedent's gross estate includes the value of any property in which the decedent had a qualified income interest for life and for which a deduction was allowed for the transfer of such property to the decedent under Section 2056(b)(7). Section 2044(a), however, left open a significant loophole. If, for example, the surviving spouse who received QTIP property sold her income interest in the QTIP property for its fair market value, she would avoid transfer taxes altogether. The sale would not constitute a gift, because it was made at fair market value. There would be no transfer of the remainder interest by the surviving spouse, because she had no interest in the QTIP trust at her death. Estate tax would be eliminated, rather than deferred. In order to close the loophole, Section 2519 was enacted as part of ERTA.

B. IRC Section 2519

Section 2519 operates from the premise that the entirety of QTIP property passes to someone other than the surviving spouse if there is an inter vivos transfer of any of the qualifying income interest. Section 2519 has broad application, and provides that any disposition of all or any part of the survivor's qualifying income interest in the QTIP property, whether by gift, sale or otherwise, triggers an immediate gift tax on the remainder interest: "The bill provides that property subject to an election to be treated as qualified terminable interest property will be subject to transfer taxes at the earlier of (1) the date on which the spouse disposes (either by gift, sale or otherwise) of all or any part of the qualifying income interest or (2) upon the spouse's death."⁶

Section 2056(b)(7) provides that, for estate tax purposes, all QTIP property is treated as passing to the surviving spouse, and only to the surviving spouse.⁷ Section 2519 provides that a disposition of any part of the surviving spouse's qualifying income interest in the QTIP property constitutes an immediate taxable gift of all interests in the QTIP property to a person other than the surviving spouse, except the income interest itself. In other words, any inter vivos disposition of any portion of the QTIP property will be treated as a gift of the entire remainder interest.

The amount treated as a transfer under Section 2519 is the fair market value of the entire QTIP property determined on the date of disposition, less the value of the qualifying income interest on that date.⁸ In addition, as noted below, in the event of a disposition of any part of the income interest for less than fair market value, that difference is also treated as a taxable gift.

C. IRC Section 2511

...