(Parker Tax Publishing June 2024)
The Tax Court held that a taxpayer did not incur gift tax liability when marital trusts in which she held an income interest for life, and with respect to which a qualified terminable interest property (QTIP) election was made on her late husband's estate tax return, were terminated by a state court and the underlying property held by the trusts consisting of shares of stock was distributed to the taxpayer because she made no gratuitous transfer as required by Code Sec. 2501. The court further found that the taxpayer's estate was not liable for gift tax on the sale of the shares because, after the termination of the marital trusts, her qualifying income interest for life in QTIP terminated and therefore, Code Sec. 2519 did not apply to the sale. Estate of Anenberg v. Comm'r, 162 T.C. No. 9 (2024).
Background
Sally Anenberg was married to Alvin Anenberg. Sally and Alvin owned the Al-Sal Oil Company (Al-Sal). In 1987, Sally and Alvin established a family trust. After Alvin's death in 2008, property held in the family trust, including shares in Al-Sal, passed to marital trusts in which Sally held an income interest for life and Alvin's children held contingent remainder interests. A qualified terminable interest property (QTIP) election was made on Alvin's estate tax return for the property passing to the marital trusts under Code Sec. 2056(b)(7), and Alvin's estate claimed a corresponding marital deduction with respect to the QTIP.
In March 2012, with the consent of Alvin's children and Sally, a state court terminated the marital trusts, and all of the underlying property held by those trusts was distributed to Sally. After Sally made an intervening gift of a portion of the Al-Sal shares to Alvin's children in August 2012, she sold the remaining shares from the marital trusts to Alvin's children and grandchildren in September 2012 for interest-bearing promissory notes for the purchase price of the shares. Sally filed a gift tax return for 2012 and, in relevant part, reported gift tax only for the August 2012 gift of Al-Sal shares to Alvin's children. Sometime later, Sally passed away.
The IRS examined Sally's 2012 gift tax return and issued a notice of deficiency to her estate determining that the termination of the marital trusts and sale of the Al-Sal shares for promissory notes was a disposition of Sally's qualifying income interest for life in QTIP under Code Sec. 2519. The IRS determined that Sally's estate was liable for gift tax on the value of the QTIP minus the value of Sally's qualifying income interest for life. The IRS also determined an accuracy-related penalty. Sally's estate petitioned the Tax Court to challenge the IRS's determinations.
Marital Deduction, QTIP, and Gift Tax Rules
Upon the death of a citizen or resident of the United States, Code Sec. 2001(a) imposes a tax on the taxable estate transferred to the decedent's heirs. In computing the amount of the taxable estate, Code Sec. 2056(a) and (b)(7) and Reg. Sec. 20.2056(a)-1(a) allow a deduction for the value of property passing from the decedent to his or her surviving spouse (the marital deduction). The policy behind the marital deduction is that property passes untaxed from the first spouse to die to the surviving spouse, but is then included in the estate of the surviving spouse.
Under Code Sec. 2056(b), the marital deduction is generally not allowed for "terminable interest" property passing to the surviving spouse (the terminable interest rule). A terminable interest is an interest passing from the decedent to the surviving spouse that will end on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur. The purpose of the terminable interest rule is to deny the marital deduction for transfers between spouses if the transfer has been structured to avoid estate tax when the surviving spouse dies.
Code Sec. 2056(b)(7) provides an exception to the terminable interest rule for qualified terminable interest property (QTIP). The provision allows a marital deduction for QTIP even though the surviving spouse receives only an income interest and has no control over the ultimate disposition of the property. Under Code Sec. 2056(b)(7)(B), three requirements must be met for terminable interest property to qualify as QTIP: (1) the property must pass from the decedent, (2) the surviving spouse must have a qualifying income interest for life in the property, and (3) the executor of the estate of the first spouse to die must make an affirmative election to designate the property as QTIP. For these purposes, Code Sec. 2056(b)(7) creates a legal fiction under which the surviving spouse is treated as receiving all of the QTIP passing from the deceased spouse, when in reality the surviving spouse has acquired only a lifetime income interest in that property.
Other Code provisions continue the fiction that the surviving spouse owns the QTIP outright to ensure that, if not consumed by the surviving spouse during her lifetime, the QTIP ultimately is subject to either the estate or gift tax. Specifically, Code Sec. 2044 requires that, upon the surviving spouse's death, the value of her gross estate includes the value of any QTIP. As a corollary, Code Sec. 2519 addresses dispositions of qualifying income interest for life in any QTIP during the surviving spouse's lifetime, triggering potential gift tax in certain circ*mstances. Operating together, these provisions generally mean that a QTIP election produces the same tax outcome that the marital deduction would have if the surviving spouse in fact owned the QTIP - namely, deferral until the surviving spouse dies or conveys his or her interest in the QTIP by gift. Code Sec. 2519 provides that for gift tax and estate tax purposes, any disposition of all or part of a qualifying income interest for life in a QTIP is treated as a transfer of all interests in the QTIP other than the qualifying income interest. Accordingly, for gift and estate tax purposes, Code Sec. 2519 treats any disposition of the surviving spouse's income interest in QTIP as if the surviving spouse transferred 100 percent of the remainder interests in QTIP.
The estate and the IRS filed competing motions for partial summary judgment. The parties agreed that, following Alvin's death, Sally owned a qualifying income interest for life in QTIP (including the lifetime income interest in the Al-Sal shares). But they disagreed on the application of Code Sec. 2519 to Sally's 2012 transactions with respect to the Al-Sal shares. The IRS contended that Sally disposed of her qualifying income interest for life in the QTIP within the meaning of Code Sec. 2519 at one of two times: (1) when Sally agreed to the termination of the marital trusts and accepted the distribution of a complete ownership interest in all the trusts' assets, including the Al-Sal shares; or (2) when Sally, having accepted the shares from the marital trusts, sold them in exchange for promissory notes. In the IRS's view, either one of these two events was a "disposition" sufficient to trigger Code Sec. 2519. The IRS therefore contended that Sally was treated as transferring the full value of the QTIP (the Al-Sal shares) less the value of her qualifying income interest as a gift, resulting in a gift tax liability of more than $9 million and related penalties. The estate disagreed, arguing that the 2012 transactions, taken together, amounted to no more than a permissible conversion of Sally's qualifying income interest for life in the QTIP into an equivalent interest in other property. Alternatively, the estate contended that even if there was a disposition, no gift tax was due because Sally did not make a gift. Instead, she received full and adequate consideration for the property she was deemed to transfer.
Tax Court's Analysis
The Tax Court granted the estate's motion for partial summary judgment and denied the IRS's motion for partial summary judgment.
The court held that, assuming Sally's relinquishment of her interest in the marital trusts in exchange for the Al-Sal shares was a disposition, Code Sec. 2519(a) treated her as having transferred away (but not necessarily by gift) all the interests in the Al-Sal shares other than her qualifying income interest. The court found that Sally received free and clear the underlying property that Code Sec. 2056(b)(7) deemed her to have received from Alvin and thus, she gave away nothing of value as a result of the deemed transfer. Accordingly, the court found that the termination of the marital trusts did not result in any gratuitous transfer by Sally, deemed or otherwise. Because there was no gratuitous transfer, she made no gift.
The court further held that the estate was not liable for gift tax on the sale of Al-Sal shares for promissory notes. In the court's view, there were at least two reasons why the transaction could not have triggered Code Sec. 2519(a). First, if the termination of the marital trusts and distribution of the trusts' assets to Sally constituted a disposition of her qualifying income interest for life in QTIP (as the court assumed above), then that event would have already triggered Code Sec. 2519, and that provision would no longer apply at the time Sally sold the shares. Second, even if the termination of marital trusts and distribution of QTIP to Sally was not a disposition, the court found that Sally's qualifying income interest for life in the QTIP would still have ceased to exist at that point, eliminating the mechanism needed to trigger Code Sec. 2519 in the future. According to the court, it is axiomatic that a surviving spouse must hold a qualifying income interest for life to implicate Code Sec. 2519. When the marital trusts were terminated, the property interest Sally received was outright ownership of the Al-Sal shares, not an income interest. Therefore, the court concluded that Sally no longer held a qualifying income interest for life as defined by Code Sec. 2056(b)(7)(B)(ii), and consequently her sale of the Al-Sal shares could not trigger Code Sec. 2519.
For a discussion of the gift tax rules for dispositions of certain life estates, see Parker Tax ¶222,310.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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