Early terminations of QTIP trusts: The cautionary case of McDougall

Since the enactment of the Economic Recovery Tax Act of 1981, P.L. 97-34, qualified terminable interest property (QTIP) trusts have become an integral part of estate planning for many married couples, especially for spouses who were previously married and have children from a prior marriage. QTIP trusts typically provide lifetime financial security and asset protection for the surviving beneficiary-spouse while offering the grantor-spouse estate tax deferral along with control over the ultimate disposition of the trust assets after the beneficiary-spouse’s death.

Despite the benefits of QTIP trusts, a beneficiary-spouse may on occasion find a trust’s terms too restrictive, overly burdensome, or simply unwanted, prompting a desire to commute the beneficial interest and terminate it; gift or sell a portion of it to others; or perhaps purchase the remainder interests, permitting all trust assets to be distributed outright to the beneficiary-spouse. As the recent case of McDougall, 163 T.C. No. 5 (2024), highlights, before a beneficiary-spouse exits a QTIP trust, the special gift tax rules applicable to QTIP trusts under Sec. 2519 must be carefully analyzed to avoid, or at least minimize, potential adverse gift tax consequences to all beneficiaries involved.

QTIP trust qualification requirements

Prior to 1982, for a spousal transfer to qualify for the unlimited marital deduction, the transfer had to be made outright to the beneficiary-spouse or to a trust satisfying the requirements of Sec. 2056(b)(5), which required the beneficiary-spouse to be granted a power to appoint trust assets to themselves or their estate. This resulted in the grantor-spouse having to balance on the one hand the benefits of using the estate tax marital deduction to defer potential estate taxes and preserve the estate against, on the other, the potential risk that those assets could be distributed upon the surviving spouse’s death to beneficiaries the grantor spouse never intended to benefit. With the advent of the QTIP trust, the grantor spouse could finally receive the estate tax deferral benefits of the marital deduction while retaining dispositive control of the trust assets after the death of the surviving spouse. However, to do so, certain qualifying requirements must first be met.

Most estate planning practitioners are familiar with the stringent qualifying requirements for QTIP trusts. Under Sec. 2056(b)(7) or 2523(f), as the case may be, a QTIP trust is eligible for the estate tax marital deduction or gift tax marital deduction, respectively, if:

• A timely QTIP election is made;
• The trust instrument gives the spouse-beneficiary a qualifying life interest in trust, meaning that the spouse-beneficiary is entitled to the trust accounting income payable no less than annually; and
• No person has the power to appoint any part of the property to any person other than the spouse-beneficiary.

Under Sec. 2044, upon the death of the spouse-beneficiary, the QTIP trust assets are included in that spouse’s gross estate, perhaps resulting in potential estate taxes. However, under Sec. 1014(b)(9), those assets should receive a step-up in income tax basis if they are includible in the gross estate.

Special gift tax rules for QTIP trusts

Perhaps less familiar to practitioners are the special gift tax rules that apply specifically to QTIP trusts and are designed to ensure that QTIP trust assets receiving the marital deduction do not escape transfer taxation later. In short, QTIP trust assets will either be includible in the spouse-beneficiary’s estate at death under Sec. 2044 or, if gifted during the spouse-beneficiary’s lifetime, subject to gift taxes under Secs. 2519 and 2511. Assuming there are no spendthrift limitations on the QTIP trust beneficiaries, or those limitations have been sufficiently removed by a trust amendment or decanting, transfers of QTIP trust interests among beneficiaries may result in a variety of gift tax consequences.

For example, if a spouse-beneficiary gifts or sells all or any part of the qualifying income interest in a QTIP trust, Sec. 2519(a) treats it as a gift of the entire value of the QTIP trust, other than the qualifying income interest, which is separately subject to gift tax under Sec. 2511. Consequently, a gift or sale of even a portion of the trust can result in a deemed gift of the whole trust. Alternatively, if the spouse-beneficiary’s life income interest is commuted, with the spouse-beneficiary receiving the actuarial present value of that interest and the remainder beneficiaries taking the rest, the spouse-beneficiary is treated under Sec. 2519(a) as having made a gift to the remainder beneficiaries of the fair market value of the trust minus the present value of the spouse-beneficiary’s lifetime interest determined under Sec. 7520. The gift is in essence a “net gift” because the spouse-beneficiary is entitled to recover the payment of gift tax under Sec. 2207A(b). However, there is no gift from the remainder beneficiaries to the spouse (Chief Counsel Advice memorandum 202118008).

Another possible scenario involves the spouse-beneficiary receiving less than the present value of the qualifying income interest. In that case, Sec. 2519 subjects the remainder interest to gift tax, while the gifted life income interest is subject to gift tax under Sec. 2511. If the surviving spouse were to gift all their life income interest in the trust to the remainder beneficiaries, the gift would be subject to Sec. 2511 rather than Sec. 2519, and there would be no right of recovery to gift tax under Sec. 2207A.

If the beneficiary-spouse purchases the remainder interest of the QTIP trust from the remainder beneficiaries, thus causing a merger of the current and future beneficial interests, the QTIP trust assets are included in the spouse’s gross estate under Sec. 2044 as QTIP trust assets, but this is offset by the purchase price paid to the remaindermen for their remainder interests. Rev. Rul. 98-8 holds that a beneficiary-spouse acquiring a remainder interest in a QTIP trust by transfer of property or cash to the holder of the remainder interest results in a gift under Secs. 2519, 2511, and 2512. The amount of the gift is equal to the greater of (1) the value of the remainder interest or (2) the value of the property or cash transferred to the holder of the remainder interest.

Finally, if the remainder beneficiaries gift the remainder interest to the beneficiary-spouse, this would also cause a trust termination, with the trust assets passing to the beneficiary-spouse. This was the case in McDougall. There, the Tax Court addressed the issue of whether such a trust commutation results in separate gifts from the beneficiary-spouse to the remainder beneficiaries and from the remainder beneficiaries to the beneficiary-spouse.

The facts in McDougall

After Clotilde McDougall died in 2011, her estate passed to a QTIP trust for the benefit of her husband, Bruce, who held an income interest, and their two children, Linda and Peter, the remainder beneficiaries. By 2016, the trust assets had doubled in value to approximately $108 million. That same year, Bruce and his two children, acting individually and as virtual representatives of the contingent remainder beneficiaries, entered into a nonjudicial agreement whereby the entirety of the trust assets were distributed to Bruce, and the QTIP trust terminated. The same day, Bruce transferred substantially all the QTIP trust assets to trusts benefiting Linda and Peter and their respective descendants in exchange for secured promissory notes. Bruce and his children filed separate gift tax returns stating there was no gift tax, as they claimed the transactions were offsetting reciprocal gifts. The IRS issued notices of deficiency stating that Bruce had made a gift of the remainder interest under Sec. 2519 and that the children made a gift in an equal amount back to Bruce under Sec. 2511.

The court’s decision: Following its decision in Estate of Anenberg, 162 T.C. 9 (2024), the Tax Court held that Bruce had not made any taxable gift under Sec. 2501 to his children in the commutation and subsequent sale, reasoning that he did not make any transfer by gift, and Linda and Peter received nothing in return, even if it resulted in a transfer of property under Sec. 2519(a) when the trust was commuted. However, the Tax Court held that the children had made taxable gifts to their father, Bruce.

Observations

Under McDougall, as supported by Anenberg, when all QTIP trust assets pass to the beneficiary-spouse in a commutation, the beneficiary-spouse avoids being subject to gift tax on the transfer. By contrast, in a traditional commutation, when the beneficiary-spouse receives all or a portion of the actuarial present value of that interest, McDougall would not save the beneficiary-spouse from being treated as making a gift of the entire remainder interest under Sec. 2519. Also notable is that remainder beneficiaries may be subject to gift tax by agreeing to an early termination of a QTIP trust. Thus, if the beneficiary-spouse wishes to terminate a QTIP trust early, careful planning is necessary to avoid a looming trap for the unwary, which just may be all parties involved.

— James Philip Head, J.D., LL.M., AEP, is a tax managing director with the National Tax Office (Private Client Services) at BDO USA PC in Washington, D.C.