What distributions can be made from a marital trust?

• Jurisdiction: United States
• Author: Tiernan, Peter B.
• Date: 01 March 1997

Since its introduction by The Economic Recovery Tax Act of 1981, the unlimited marital deduction has been increasingly used as a way of deferring estate taxes until the surviving spouse's later death. Although this tax deferral can be accomplished by simply making an outright devise to the surviving spouse, the use of a marital deduction trust is also widely used to achieve this result. The reasons for using a marital trust as opposed to an outright transfer to the surviving spouse are many and varied and will not be discussed herein. However, since the marital deduction only accomplishes the deferring of estate taxes until the surviving spouse's death, whenever a large portion of the husband's and wife's combined estate is held in the marital trust of the first spouse to die, other techniques must be used to minimize or eliminate estate taxes upon the surviving spouse's death.

In light of the Tax Court's recent decision in the Estate of Lillian L. Halpern v. Commissioner, 70 TCM 229 (1995), and other recent Tax Court decisions, one new option a practitioner may want to consider under the above circumstances is to distribute assets from the marital trust to descendants of the surviving spouse. Under certain circumstances, this might allow the surviving spouse to treat these distributions as, gifts to her descendants and, by taking advantage of annual gift tax exclusions, she might be able to reduce the amount that will be subject to estate tax at her death. However, the type of marital trust and its particular terms significantly affect the tax consequences of the distribution.

For purposes of this article, it is assumed that: 1) this was a first marriage; 2) the husband has predeceased his wife, leaving a marital trust containing $3 million; 3) the surviving spouse has a separate estate of $1 million; 4) the surviving spouse is hesitant to make gifts from her separate assets, although she is receptive to making gifts from the marital trust; 5) the terms of the marital trust provide that the surviving spouse is entitled to all the income from the trust, as well as any principal amounts necessary for her health, support, and maintenance; 6) there is no authorization for any other principal distributions from the trust to the surviving spouse or to anyone else; and 7) the wife's gross estate is valued at $3,400,000 or more upon her death. Under these assumed facts, every $10,000 amount distributed from the marital trust to the wife's descendants will result in a transfer tax savings of $5,500 upon the surviving spouse's death.

Significance of Applicable State Law

When considering making distributions from a marital trust, state law must be taken into account. As stated by the Tax Court in Helvering v. Stuart, 317 U.S. 154 (1942), "[a]lthough, for purposes of Federal taxation, the classification of rights and powers is a matter of Federal law, the existence and nature of the interests to be classified is a matter of State law." The determination of whether a distribution from a marital trust will be recognized as effective for tax purposes involves a question of the existence of "an interest" in those distributed assets as of the surviving spouse's death. This involves interpretation of state law. If a state court would have determined that the distributions were ineffective and ordered the distributed assets returned to the marital trust, then the marital trust will be deemed to own the distributed assets. The distributed assets consequently would be included in the surviving spouse's gross estate for federal estate tax purposes.

In regard to the cases that will be discussed herein, it is also important to note that the courts all indicate that the question is whether a state court would determine "after the fact" that distributions were effective rather than whether the state court would have given prior approval to the distributions. This approach is definitely pro-taxpayer, since most state cases indicate that distributions of this type would not be given prior court approval.

General Power of Appointment Marital Trust

There are three recent cases and one private letter ruling dealing with distributions from a general power of appointment marital deduction trust. The first two cases, Estate of Council v. Commissioner, 65 TC 594 (1975), and the Estate of Hartzell v. Commissioner, TC Memo. 1994-576, involve distributions from general power of appointment marital trusts. In each case, the trustee was given at least some discretion in the trust instrument to make distributions to the surviving spouse. The issue was whether the language setting forth the circumstances in which corpus could be invaded for the surviving spouse was broad enough to permit the trustees to make the distributions in question.

A significant aspect of both cases is that the Tax Court indicated the point of time for judging whether distributions from a marital trust are effective. Both cases indicate that the issue is whether a state court would have approved the distributions "after the fact" as opposed to whether a state court would have given prior approval to the distribution. In both cases, the Tax Court decided that the appropriate state court would have approved these distributions "after the fact." As a consequence, IRC [sections] 2041 did not cause inclusion of the distributions in the surviving spouse's gross estate.

In the most recent and most significant of the cases dealing with distributions from a marital trust, there was absolutely no authority granted in the trust document authorizing the type of distributions made. Estate of Lillian L. Halpern v. Commissioner(1) involved direct distributions from a general power of appointment marital trust to Mrs. Halpern's children and their families. The decedent's husband died, leaving a will which created a marital trust for his wife, Lillian L. Halpern. The will provided that all of the income of the marital trust went to Mrs. Halpern during her life and so much of the principal as the trustees deemed necessary or...