The Tax Court held that the amounts of gift tax paid by the recipients of a QTIP remainder are includible in the transferor’s gross estate under Sec. 2035(b).
In 1991, Howard and Anne Morgens, as settlors, executed the Morgens Family Living Trust Agreement establishing a revocable trust (the MFLT) to administer assets they contributed to it. Under the trust agreement (as later amended), after the death of the first spouse, the corpus of the trust was to be distributed into two separate trusts: the survivor’s trust and the residual trust. The portion of the trust representing the surviving spouse’s one-half of the community property would be allocated to the survivor’s trust, and the portion representing one-half of the community property of the first spouse to die would be allocated to the residual trust.
With respect to the residual trust, the trust agreement provided that after certain gifts, the balance of the residual trust would remain in trust for the benefit of the surviving spouse for that spouse’s lifetime. The surviving spouse had an income interest in the trust that entitled the spouse to receive the net income of the trust in quarterly or more frequent installments during his or her life.
When Mr. Morgens died, the MFLT was separated into a survivor’s trust and a residual trust as required by the trust agreement. Mr. Morgens’s estate made the election under Sec. 2056(b)(7) to treat the property transferred to the residual trust as qualified terminable interest property (the QTIP election), thus qualifying the property for the marital deduction.
Afterward, Mrs. Morgens and the holders of the remainder interests in the residual trust agreed that if Mrs. Mor-gens transferred her interest in the trust, the holders of the remainder interests would indemnify her for any gift tax liability on the transfer. Later, the residual trust was split under court order into two separate trusts (A and B). After the split, Mrs. Morgens retained a right to the income from the separate trusts for life, and the agreement regarding the indemnification for gift taxes in the event of a transfer of her interests continued to apply to both trusts.
In December 2000, Mrs. Morgens transferred her income interest in residual trust A as gifts to the remainder beneficiaries in the same proportions as their respective remainder interests, thereby triggering a transfer of the QTIP remainder under Sec. 2519. She transferred her interest in residual trust B in a similar transaction in January 2001. Both transfers resulted in large gift tax liabilities, which the trustees of the respective trusts paid.
Mrs. Morgens died in August 2002. The executor of her estate timely filed an estate tax return on November 24, 2003, pursuant to an extension. On the return, the executor did not include the amounts of gift tax paid by the trustees for the 2000 and 2001 deemed transfers in Mrs. Morgens’s gross estate on the ground that those amounts were not gift tax paid by Mrs. Morgens or her spouse within three years of her death. The IRS issued a notice of deficiency based on the unreported gift tax on the deemed transfers, and the executor of the estate challenged the deficiency determination in Tax Court.
Under Sec. 2035(b), the amount of a decedent’s gross estate is increased by the amount of any tax paid by the decedent or his or her estate on any gift made by the decedent or his or her spouse during the three-year period preceding the decedent’s death.
Ordinarily, a marital deduction is not allowed for terminable interest property passing from a decedent to his or her surviving spouse under Sec. 2056 (terminable interest rule). A terminable interest is an interest passing from a decedent to his or her 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. Sec. 2056(b)(7) 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 Sec. 2056(b)(7), a decedent may pass to his or her surviving spouse an income interest in property for the spouse’s lifetime.
After the death of the surviving spouse, under Sec. 2044 the value of his or her gross estate includes the value of the QTIP. Sec. 2207A allows the estate of the surviving spouse to recover the amount by which the surviving spouse’s estate tax is increased by the inclusion of the QTIP in the estate from the QTIP recipients.
As a corollary to Sec. 2044, Sec. 2519 applies similar rules to dispositions of QTIP during the surviving spouse’s lifetime and treats any disposition of all or part of a qualifying income interest for life as a transfer of all interests in QTIP other than the qualifying income interest. If gift tax is due upon the deemed transfer of the QTIP by a surviving spouse, Sec. 2207A(b) permits the surviving spouse to recover the gift tax attributable to the deemed transfer from recipients of the QTIP.
The Parties’ Arguments
The IRS argued that Mrs. Morgens was personally liable for the gift tax attributable to the 2000 and 2001 deemed transfers and that Sec. 2207A(b) did not shift her liability to the trustees of the residual trust. Because Mrs. Morgens remained liable for the tax, the IRS further contended that Sec. 2035(b) required that the amounts of gift tax paid on the 2000 and 2001 deemed transfers be included in Mrs. Morgens’s gross estate as gift tax paid within three years of her death, consistent with the Tax Court’s decision in Estate of Sachs, 88 T.C. 769 (1987).
The estate argued that because the ultimate responsibility for paying the gift tax on the Sec. 2519 deemed transfers lay with the trustees of the residual trusts, Sec. 2035(b) did not apply to Mrs. Morgens in this case, either because she ultimately did not bear the financial burden of the gift tax for the transfers or the gifts were not net gifts that were properly subject to the statute. The Morgens’s estate argued in the alternative that application of Sec. 2035(b) to a QTIP transfer was incompatible with the QTIP regime.
The Tax Court’s Decision
The Tax Court held that the amount of gift tax paid with respect to the 2000 and 2001 deemed transfers of the QTIP was includible in Mrs. Morgens’s gross estate. In rejecting the estate’s argument about the payment of the tax, the court found that the estate wrongly equated the financial burden for the gift tax on the transfers with the liability for the taxes. Although the legislative history showed that Congress intended that the financial liability of the gift tax on deemed QTIP transfers should fall on the transferees, the Tax Court noted that the Code and the regulations clearly state in a number of ways that the liability for the tax remained on the surviving spouse. It also noted that although private parties were free to allocate the burden of a tax, they could not alter who was initially liable for the tax.
The Tax Court also disagreed with the estate’s argument that Mrs. Morgens’s transfers of her income interests were not net gifts (i.e., transfers of the full amount of the interest less the amount of gift tax paid). The Tax Court stated that, as it had held previously in Estate of Sachs, the gift tax on a net gift was includible in the donor’s estate even if the donees were contractually obligated to pay the gift tax. The estate, however, argued that a net gift only existed where the donor was the source of the funds used to pay the gift tax. The Tax Court explained that this ignored the premise of the QTIP regime, under which the surviving spouse is treated as receiving the entire QTIP from his or her spouse and then transferring it either at death or in an inter vivos transfer. Because the surviving spouse (as it had previously discussed) was liable for the tax on the transfer, the Tax Court held that the transfers were net gifts no different than the one in Estate of Sachs, and thus the gift tax on them was includible in the estate.
Finally, the court also rejected the estate’s various arguments that applying Sec. 2035(b) was somehow contrary to the QTIP regime. The estate claimed that this point was proved either by the plain language of the statutes, by the legislative history of Sec. 2707A, or by the application of the rules of statutory construction. The Tax Court found that an analysis of the plain language of the Code sections did not lead to the conclusion that Sec. 2707A had an effect on the application of Sec. 2035(b) to QTIP transfers and that the legislative history for Sec. 2707A did not provide any clear indication that Congress intended this result.
The Tax Court further found that there was no conflict between the Code sections, so the rules of statutory construction (which would favor the later-enacted section, Sec. 2707A) did not apply. According to the Tax Court, the rationale behind Sec. 2035(b), which is to equalize the treatment of transfers at death and transfers in contemplation of death (deathbed transfers), applies to QTIP just as it does to other property. If Sec. 2035(b) did not apply, a deathbed transfer of a QTIP interest could permanently prevent the inclusion of the gift tax on a QTIP transfer from estate tax, thus providing a preference for deathbed QTIP transfers over QTIP transfers at death.
The estate here tries to have its cake (the benefit of the marital deduction for the QTIP property for Mr. Morgens’s estate) and eat it too (a reduced value for the QTIP property in Mrs. Morgens’s estate via the deathbed transfer of her income interest in the property). The Tax Court properly distinguished between the transfer of financial liability for the tax and the legal liability for the tax and provides an instructive reminder that the QTIP election carries both benefits and burdens for spouses and their estates.
Estate of Anne W. Morgens, 133 T.C. No. 17 (2009)