General Practice, Solo & Small Firm DivisionMagazine
Estate and Financial Planning
Funding Marital Trusts with Special Assets
By Randall J. Gingiss
Closely Held Business Interests. A significant problem in funding a marital trust with interests in a closely held business is that these interests often produce little or no income. To address this problem, the client may recapitalize the business during his or her lifetime into preferred and common shares or interests, with the client holding all of the interests until death. Following the client’s death, the personal representative allocates the frozen shares to the marital trust and the growth shares to the nonmarital trust.
A valuation issue might arise when allocating an interest in a closely held business to a marital trust. For instance, in Chenoweth v. Commissioner, 88 T.C. 1577 (1987), the decedent’s estate included all of the stock in a closely held corporation. The decedent’s will gave 51 percent of the stock to his widow. The court held that, for purposes of calculating the amount of the marital deduction, this 51 percent interest should carry a control premium, effectively making the value of the stock higher for marital deduction purposes than for gross estate purposes. Continuing with this principle, the IRS has relied on Chenoweth and Code § 2056 to argue for minority discounts in gifts of minority interests to marital trusts when the decedent’s estate included a controlling interest in the business.
If a marital trust holds a controlling interest in a closely held company as a result of a Chenoweth maneuver, the interest may attract a control premium in the spouse’s estate. The trustee of the marital trust might attempt to avoid the premium by distributing a small interest in the company to the surviving spouse, who would then give it away. The fiduciary should think carefully about the timing of the transaction. In Estate of Murphy, T.C. Memo ¶ 90,472 (1990), a surviving spouse attempted to avoid a control premium in her estate by giving a small percentage of a closely held business to her children 18 days before her death. The Tax Court disallowed a minority discount on the retained shares, arguing that there was no substantial reduction in the spouse’s control because, with her children, she still owned a controlling interest.
Another issue can arise when the decedent’s estate owns an undivided interest in an asset. Under Bonner v. United States, 84 F.3d 196 (5th Cir. 1996), if a surviving spouse’s gross estate includes 100 percent of an asset, and he or she owns part of that asset outright and a QTIP trust owns the other part, the estate need not aggregate the interests for valuation purposes. Because each interest is a fractional interest, the estate of the surviving spouse is entitled to a fractional share discount for both interests for gross estate valuation purposes.
When both spouses own undivided interests in an asset, they should consider leaving the interest to a QTIP trust rather than outright or in a general power of appointment trust. Under Bonner, a surviving spouse’s estate should be able to take a discount for two fractional interests in the same asset included in the surviving spouse’s estate: the surviving spouse’s interest and the interest owned by the QTIP trust. If the first spouse to die leaves his or her fractional interest outright to the surviving spouse, Bonner will not apply and the two interests will be merged for gross estate valuation purposes.
S Corporation Stock. For a trust to own stock in an S corporation, the trust must either be a grantor trust under Code §§ 671-678 (Subpart E Trust), a "Qualified Subchapter S Trust" (QSST) or an "Electing Small Business Trust" (ESBT). During the term of the trust, the trustee must distribute all the net income of the QSST to the QSST beneficiary. A general power of appointment marital trust can also qualify as a QSST, provided that the trust instrument does not give the spouse an inter vivos power of appointment. A general power of appointment marital trust could also qualify as a grantor trust if the spouse had an inter vivos right to withdraw trust assets. Additionally, a general power of appointment trust could theoretically be an ESBT.
A QSST can accumulate income after all S corporation shares are sold or distributed. The beneficiary of a QSST, not the trustee, makes the QSST election. Because the beneficiary is the taxpayer, a surviving spouse with a beneficial interest in a QSST marital trust must report the trust’s proportionate share of the S corporation income on his or her individual income tax return but may not necessarily have the cash to pay the tax. An additional tax problem can arise if the QSST sells S corporation stock on the installment method. The disposition of an installment note received in a sale causes the taxpayer to lose the right to report the gain on the sale on the installment method, requiring the taxpayer to recognize all previously unrecognized gain.
Income in Respect of a Decedent. Income in respect of a decedent (IRD) under Code § 691 includes unpaid salary, commissions, life insurance residuals, installment obligations and account balances for pensions and IRAs. If a fiduciary must allocate assets to a marital trust based on a pecuniary marital formula, funding the marital gift with an item of IRD will trigger recognition of the income inherent in the item. One way to avoid acceleration of income is to specifically give the item of IRD to the marital trust.
Retirement Benefits. Clients frequently wish to take advantage of the minimum distribution rules for qualified pension plans and IRAs and also defer the estate tax on those benefits by passing them to the surviving spouse. It is possible to pay qualified plan or IRA benefits to a marital trust and obtain both of these benefits. The distributions from the plan or IRA must meet the "all income" requirement to satisfy the QTIP rules. A problem will exist if the minimum required distribution does not satisfy the "all income" requirement because the distribution is less than the "accounting" income of the plan or IRA assets in a given year. To avoid this problem, the beneficiary designation should direct a payout of the greater of "all income" or the minimum required distribution. Code § 401(a)(9) dictates the required minimum distributions from a qualified plan or IRA.
According to the proposed regulations under Code § 401(a)(9), a trust cannot be a "designated beneficiary" for purposes of determining minimum required distributions unless: (1) the trust is valid under state law; (2) the trust is irrevocable; (3) the beneficiaries are identifiable from the trust instrument; and (4) a copy of the trust agreement is provided to the plan administrator.
Artwork, Residences and Other Nonproductive Property. Putting assets such as expensive artwork or a residence in the marital trust may be necessary to allow the surviving spouse to continue to use these assets. Section 12 of the Revised Uniform Principal and Income Act recognizes beneficial use of such property as income to the income beneficiary. The trustee of a marital trust may invest a certain percentage of the property of the trust estate in assets that produce only income.
Randall J. Gingiss is an associate professor at the University of South Dakota School of Law in Vermilion, South Dakota, and is chair of the Probate Division’s Tax Aspects of Lifetime Transfers Committee.
- This article is an abridged and edited version of one that originally appeared on page 13 in Probate and Property, March/April 1998 (12:2).