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

• Author: Kurtz, N. Patricia
• Position: Qualifying terminable interest property

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...