Tax Planning with QTIP Trust Assets

“Tax Planning with QTIP Trust Assets,” that is the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow John Challis of St. Louis, Missouri.

Tax Planning with Qualified Terminable Interest Property, better known as QTIP Trust Assets, presents unique opportunities and potential pitfalls for estate planners. In this episode of the ACTEC Trust and Estate Talk, we’ll explore strategies for maximizing tax efficiency, navigating basis adjustments, and helping clients make the most of QTIP Trusts.

ACTEC Fellow Tim Halleron of Chicago will share his expertise and offer tips for estate planners. Welcome, Tim.

Tim Halleron:  Thank you, John. Thanks for having me. I thought I’d focus on just a few items with respect to post-death planning with a surviving spouse, and in particular, involving QTIP Trust.

Post-Death Basis Adjustments and Portfolio Rebalancing

One, you had mentioned the step-up in basis. And one thing I always think of is, let’s not get emotional about holding assets post-death. Post-death basis adjustments are a great time to look at a portfolio, sell assets if necessary, and rebalance, and it’s a tax-free time to do it. So, we have a lot of instances where the fiduciary or the surviving spouse are kind of emotionally attached to certain assets, in particular, even marketable securities, where there’s a readily available market to diversify. I always emphasize to clients that they shouldn’t feel emotional about a portfolio that’s been put together by the first spouse and rather take it as a great opportunity for a tax-free diversification and rebalancing.

A couple of other items: First, why don’t I touch on Section 2519 as a planning tool and this gets into the recent Anenberg (Estate of Sally J. Anenberg v. Commissioner) and McDougall (McDougall v. Commissioner) cases. And McDougall, there was a follow up case that was just decided at the end of July, so this is a timely time to talk about this.

Section 2519 Planning Opportunities and Tax Risks

Under 2519, kind of a technical and in some ways counterintuitive area. So QTIP trusts are typically viewed as restricting lifetime planning because the spouse can’t access principal and can’t redirect remainder interests. I’m assuming for purposes of this discussion that the spouse’s access to the QTIP trust is limited to all income, obviously, but also would only be able to get principal distributions under a HEMS (health, education, maintenance, and support) standard, not a broad standard; or maybe even the spouse is wholly prohibitive from receiving QTIP principal distributions.

And just as a side note, even if clients want to, for some reason, restrict a spouse’s access to principal, I always think the best way to do it to allow for flexibility is to just require an independent trustee. It doesn’t have to be a corporate; it can be an individual trustee. And then if further, there’s a concern that the surviving spouse may be able to manipulate that situation or scenario by putting in their own independent trustee. You can also include removal and appointment provisions to make sure that the right people can remove and appoint the independent trustee. All sorts of ways to allow for principal distributions. And, as we see from time to time in these cases, trying to get around a trust that doesn’t allow principal distributions can lead to significant tax consequences.

Under 2519, it can really be used strategically by intentionally triggering the provision. The surviving spouse can effectively accelerate a transfer tax event. Instead of waiting for QTIP assets to be included in the surviving spouse’s estate’s death under Section 2044, instead, the spouse can cause a lifetime gift to occur at current values by essentially releasing the income interest and shifting everything to the remainder beneficiaries. Some potential benefits: can fix the transfer tax value of the assets today, shift future appreciation out of her estate, and use his or her remaining lifetime exemption. It can even reduce the taxable gift through net gift principles that can apply when a 2519 gift applies.

Conceptually, it kind of resembles other freeze techniques. The difference is it operates within the constraints of an existing QTIP structure. Some of this is theoretical because while it works in accordance with the code provision, it’s often constrained in practice because many QTIP trusts include spendthrift provisions that would prevent an assignment of the income interest by the surviving spouse. There can also be additional barriers under state law. And importantly, triggering 2519 typically terminates the spouse’s income stream, which can be economically unacceptable or impractical. Usually, the QTIP trust is set up for a reason in that the surviving spouse actually needs the money, so shifting all the QTIP assets away to a remainder beneficiary may not make practical sense.

There’s also the technical issue that even a partial disposition under 2519 can be treated as a transfer of the entire trust corpus, creating large and sometimes unintended taxable gifts. And no one in our practice likes unintended taxable gifts. While 2519 provides a pathway for advanced planning, it has to be used cautiously and with full appreciation of the consequences from a tax perspective.

The Anenberg Decision: QTIP Trust Termination and Gift Taxes

The two cases I mentioned earlier — Anenberg and McDougall — focus on QTIP terminations, commutations, transfers of interests. And in Anenberg, we saw that the Tax Court essentially looked at a situation where with the consent of all the parties — the surviving spouse and the remainder beneficiaries — they approved a court-sanctioned transaction terminating the QTIP trust and distributing all of the assets to the spouse.

The spouse then did some additional planning with the assets, gifts and sales to the remainder beneficiaries. And the court ultimately determined that the transaction resulting in the conversion of the spouse’s income interest to full ownership by the spouse was not a taxable gift. There was no taxable gift associated with that termination, at least from the surviving spouse’s perspective. And the court ultimately held that no taxable gift occurred because 2519 only applies to gratuitous transfers. Because the surviving spouse’s interest was really just converted from a QTIP trust into spouse’s full ownership of the property, the spouse never made a gratuitous transfer, and so 2519 didn’t apply with respect to that specific transaction. Once the spouse had all of the assets herself, then the planning that the spouse did prospectively, just normal gift tax principles applied. So, the surviving spouse made gifts and sales, and those were just subject to normal gift tax rules. What the court did not address — because the IRS didn’t raise it in their arguments — was whether the remaindermen made taxable gifts to the surviving spouse as a result of the trust termination. So that was footnoted in the Anenberg decision and kind of left open.

The McDougall Decisions: Taxable Gifts by Remainder Beneficiaries

Then we get to McDougall, which the original McDougall decision was in 2024. And then we just got the more recent McDougall decision. Lewis (Lewis v. Commissioner) is the other petitioner in that case or the other party in that case; so, it’s kind of Lewis and McDougall. So, in the McDougall, I’ll just call it McDougall for simplicity, but in the combined McDougall cases, the Tax Court followed the Anenberg analysis with respect to 2519 in this case where the surviving spouse and the remaindermen entered into a non-judicial settlement agreement, as opposed to a court-ordered termination. The settlement agreement effectively terminated the QTIP trust in favor of the surviving spouse. And then, as in Anenberg, the surviving spouse entered into further planning with those assets that benefited the remaindermen.

The Tax Court in McDougall actually did address both sides of the case. One, did the surviving spouse make taxable gifts as a result of the termination? And following Anenberg, the court decided the surviving spouse did not make any taxable gifts because the surviving spouse obtained all of the trust assets. And so no taxable gift by the spouse. And so therefore 2519 doesn’t apply to that side of the equation. However, The IRS did raise the issue of whether the remaindermen made gifts to the surviving spouse; and in the initial McDougall case, the Tax Court left that issue open, did conclude that the children made taxable gifts, left open the issue of valuation of those taxable gifts. Then McDougall II, comes out in late July of 2026. And the court decided that even though the surviving spouse had a limited power of appointment and could have directed the trust assets away from either of the children, therefore reducing their interest in the trust to zero, the existence of that limited power of appointment should be disregarded as purely theoretical and not really having any impact on the valuation of the potential gifts made by the children when they agreed to let the trust terminate and distribute all the assets to the surviving spouse.

The dollar amount is significant, it was $35.1 million for each of the children, which obviously uses up all of their exemption, if they haven’t already used it and imposes a gift tax on the excess, I would think that would be appealed. And so we’ll see if there’s a McDougall III or where this goes. But at the end of the day, the takeaway from the McDougall cases is that even though from a 2519 and surviving spouse perspective, there may not be a taxable gift associated with the termination of a QTIP. When you have a multi-party transaction, there’s always a risk that the other side may have made a taxable gift or there may be income tax consequences, so, thinking through all of the potential gift transactions or gift tax consequences is essential whenever you’re looking at a multi-party transaction. Probably more to come on McDougall at some point.

The No-Aggregation Rule and QTIP Trust Valuation Discounts

And then just quickly, I thought I’d turn to the no-aggregation rule, which is really a valuation rule that can be beneficial in the context of a QTIP trust. The key to advance QTIP trust planning is how trust assets are valued at the surviving spouse’s death. 2044 requires the QTIP property is included in the spouse’s gross estate — the surviving spouse’s gross estate. But the statute doesn’t address whether those assets must be combined with the surviving spouse’s own assets for valuation purposes. And courts have filled this gap by developing what’s called the “no-aggregation rule.” That provides that QTIP trust assets included in the surviving spouse’s estate are valued separately from assets the spouse owns outright. In other words, even though the QTIP property is included in the spouse’s estate for tax purposes, it is not treated as though the spouse owned it outright when determining value. Each interest, whether QTIP owned or personally owned, is valued independently.

Fractional Interests and Powers of Appointment

This rule originated in the estate of Bonner case (Estate of Louis F. Bonner, Sr. v. United States) and creates a number of opportunities for estate planning. Pre-death, during the spouse’s lifetime, you might consider fractional ownership structures:  50-50, 60-40, whatever it is — so that at the first death, you can segregate those ownership interests between the QTIP trust and the surviving spouse, and that can create valuation discounts at the second death. If you don’t have that scenario where you’ve done pre-death planning, trustees might consider distributing partial interest to the spouse prior to death from the QTIP trust to create those different ownership interests.

Importantly, courts have not generally required strict limitations on the spouse’s role. In a lot of cases, the spouse even serves as co-trustee of the QTIP trust without defeating the no-aggregation rule or the no aggregation valuation result. However, the rule is not absolute; a critical limitation arises if the surviving spouse holds a general power of appointment. In that case, courts can treat the surviving spouse as having effective ownership and require aggregation under 2041, by contrast where the spouse only holds a limited power, the non- aggregation rule generally continues to apply. Also, as always, courts can scrutinize deathbed structuring designed solely to create these discounts and transactions lacking economic substance. I think I’ll wrap up there, just a few items for people to be thinking about pre-death and post-death with respect to QTIP planning.

John Challis: Thank you, Tim, for a great discussion on tax planning with QTIP assets.

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