A Tale of Two Recent QTIP Trust Termination Cases — Anenberg and McDougall

Background on QTIP Trusts

QTIP trusts are popular estate planning tools that allow grantors to provide for a surviving spouse while maintaining control over the ultimate disposition of assets. When properly structured, these trusts qualify for the marital deduction, deferring estate taxes until the surviving spouse’s death. To qualify, the trust must give the surviving spouse a mandatory right to all income for life, prohibit anyone from appointing property away from the spouse during their lifetime, and require a QTIP election on a timely filed estate tax return.

Gift tax considerations for QTIP trusts are intricate and have far-reaching implications. If a surviving spouse makes an inter vivos gift of any portion of their income interest in a QTIP trust, it triggers special gift tax rules under Internal Revenue Code (IRC) Section 2519(a), treating it as a transfer of all interests in the trust other than the qualifying income interest. (The gift of the qualifying income interest is separately subject to gift tax under IRC Section 2511.) This provision is designed to prevent circumvention of QTIP rules and ensures that the gift is valued at the fair market value of all trust interests, minus the value of the surviving spouse’s qualifying income interest. Thus, even partial interest transfers can potentially result in a deemed transfer of the entire trust.

The terminable interest rule forms the foundation of QTIP trust taxation, ensuring that property qualifying for the marital deduction at the first spouse’s death doesn’t escape taxation at the second spouse’s death. This rule, along with other provisions, creates a comprehensive system to maintain the integrity of the unlimited marital deduction and ensure that QTIP trust assets remain in the transfer tax system. These assets are either included in the surviving spouse’s estate at death (under IRC Section 2044) or subject to gift tax if disposed of during their lifetime (under IRC Sections 2519 and 2511), effectively preventing tax avoidance while coordinating with the estate tax to avoid double taxation.

The Anenberg Case: Setting the Stage

Anenberg centered around the termination of a QTIP trust established by Alvin Anenberg for his wife, Sally. Upon Alvin’s death in 2008, significant assets were placed in a QTIP trust for Sally’s benefit, with Alvin’s children from a prior relationship as remainder beneficiaries.

In 2011, with the consent of all beneficiaries, the trustee petitioned to terminate the trust and distribute its assets to Sally. Following the distribution, Sally gifted some of these assets to trusts for Alvin’s children and sold most of her remaining interests to trusts for Alvin’s descendants in exchange for promissory notes.

The Tax Court’s Analysis in Anenberg

The Tax Court rejected the Internal Revenue Service’s (IRS) position that the QTIP trust termination and subsequent sale resulted in a taxable gift under IRC Section 2519. The court emphasized that a transfer alone is not sufficient to create gift tax liability, citing US Supreme Court precedent that defines a gift as proceeding from “detached and disinterested generosity” or similar impulses. The court compared Sally’s interests before and after the trust termination, concluding that she received more than she surrendered, as she gained full ownership and control of the assets. The court also found that Sally retained dominion and control over the assets, rendering any potential gift incomplete under Treasury Regulation § 25.2511-2(c).

The court likened the trust termination to an exercise of a power of appointment in Sally’s favor, noting that appointing QTIP assets to the surviving spouse is not treated as a disposition under IRC Section 2519 and therefore does not trigger gift tax. Importantly, the Tax Court distinguished this case from Estate of Kite, where a QTIP trust termination was part of a scheme to avoid both estate and gift tax. In Anenberg, the value of the distributed assets remained in Sally’s estate for future gift or estate taxation, preserving the integrity of the QTIP regime.

The court focused solely on whether Sally made a gift as a result of the QTIP trust termination and subsequent transactions. The potential gift tax implications for the remainder beneficiaries (Alvin’s children and grandchildren) were not considered or ruled upon in this decision.

McDougall v. Commissioner: Building on Anenberg with a Twist

The more recent case of McDougall v. Commissioner, decided on September 17, further clarified the gift tax treatment of QTIP trust commutations. This case involved Bruce McDougall and his children, Linda Lewis and Peter McDougall, following the death of Clotilde McDougall in 2011.

Upon Clotilde’s death, her estate passed to a residuary trust in which her husband, Bruce McDougall, held an income interest, and their two children, Linda Lewis and Peter McDougall, held remainder interests. Bruce, as the estate’s personal representative, elected to treat the trust property as QTIP under IRC Section 2056(b)(7), allowing for a marital deduction on Clotilde’s estate tax return.

In 2016, Bruce and his children entered into a nonjudicial agreement to commute and terminate the QTIP trust, distributing all assets to Bruce. Subsequently, Bruce sold some of these assets to new trusts established for the benefit of Linda, Peter, and their children, receiving promissory notes in exchange.

The parties filed separate gift tax returns for 2016, claiming that these transactions resulted in offsetting reciprocal gifts with no gift tax due. However, the IRS challenged this position, issuing notices of deficiency to both Bruce and his children. The IRS contended that the trust commutation resulted both in gifts from Bruce to his children under IRC Section 2519, and in gifts from the children to Bruce of their remainder interests under IRC Section 2511. Importantly, the gifts-from-children-to-parent aspect in McDougall does not appear to have been asserted by the IRS in Anenberg.

The Tax Court’s Decision in McDougall

The Tax Court, following its prior decision in Anenberg, ruled in favor of Bruce regarding his potential gift tax liability. The court held that Bruce did not make taxable gifts to his children under Section 2501, even if there was a transfer of property under Section 2519 when the QTIP trust was commuted. The court reasoned that Bruce made no gratuitous transfers, and the exchange of trust property for promissory notes did not constitute a gift.

However, the Tax Court agreed with the IRS that Linda and Peter made taxable gifts to Bruce of their remainder interests in the trust under IRC Section 2511. The court rejected the taxpayers’ argument that the transactions resulted in offsetting reciprocal gifts, emphasizing that while IRC Section 2519 may deem a transfer, it does not deem a gift from Bruce to his children.

This decision clarifies the gift tax treatment of QTIP trust commutations and highlights the potential gift tax liability for remainder beneficiaries when terminating such trusts early. It underscores the importance of careful planning and consideration of gift tax consequences when modifying or terminating QTIP trusts.

Implications for Estate Planning

These recent decisions offer several crucial takeaways for estate planners and QTIP trust beneficiaries:

1. Trust terminations of QTIP trusts that involve a distribution of property solely to the surviving spouse do not, in and of themselves, appear to trigger any gift tax consequences to the surviving spouse, as demonstrated in both Anenberg and McDougall.
2. The substance of transactions is paramount in determining gift tax consequences. Both cases emphasize the importance of looking beyond the form of the transactions to their economic reality.
3. Careful structuring of subsequent transactions is essential to avoid unintended gift tax exposure. The McDougall case, in particular, highlights the need to consider the tax implications of any transactions following the trust termination, and demonstrates that remainder beneficiaries of the QTIP trust may be subject to gift tax on the terminating distributions to the surviving spouse because they are gratuitously relinquishing an interest in trust property without receiving full and adequate consideration for it in money or money’s worth.
4. Remainder beneficiaries may face gift tax consequences when consenting to early trust termination. This aspect of McDougall adds a new dimension to the planning process for QTIP trust terminations.
   1. If the QTIP trust has a broad standard for distributions, such as best interests or “as the trustee determines,” a trustee’s exercise of that discretion to distribute assets to the spouse to allow him or her to engage in lifetime tax planning should not be subject to question by the remainder beneficiaries.
   2. If the standard is ascertainable, such as for health and support, and the trustee nevertheless distributes assets of the QTIP trust to the spouse to engage in tax planning, then the IRS could assert that the remainder beneficiaries made a gift to the spouse by failing to challenge the trustee’s exercise of discretion.

The Anenberg and McDougall decisions underscore the importance of considering all aspects of trust terminations, from the initial distribution to any subsequent transactions, and the potential gift tax implications for all parties involved. As the legal landscape continues to evolve, these cases serve as crucial reference points for professionals navigating the complex world of estate planning and QTIP trust terminations.