July 01, 2000

Balancing the GSTT Exemption and the Marital Deduction (2000, 14:04)

John B. Atkins

Balancing the GSTT Exemption and the Marital Deduction

Probate and Property, July/August 2000, Volume 14, Number 4

By John B. Atkins
John B. Atkins is a lawyer and Vice President of Private Client Services with Wells Fargo Bank Nebraska, N.A. in Omaha, Nebraska, and is a member of the Probate and Trust Division's Fiduciary Responsibility (F-1), Administration and Litigation (F-3) and Employee Benefit Planning (F-8) Committees.  

Two of the most technical areas that an estate planner may encounter are the marital deduction provisions of Code § 2056 and the generation-skipping transfer tax (GSTT) in Chapter 13. Drafting to coordinate these two areas requires great caution. This is especially true when the client wants to use a general power of appointment marital trust under Code § 2056(b)(5).

A Typical Estate Plan

Each taxpayer has an exemption from the GSTT that is currently worth $1,030,000. To take full advantage of both GSTT exemptions in an estate plan for married taxpayers, an estate planner often creates a credit shelter trust funded with the unified credit equivalent and then devises a mechanism to preserve the difference between the unified credit equivalent and the GSTT exemption. Assuming that the estate of the first spouse to die is worth $1,030,000, the personal representative would fund a $675,000 credit shelter trust and a $355,000 marital trust. The marital trust could be either a QTIP trust under Code § 2056(b)(7) or a general power of appointment marital trust under Code § 2056(b)(5). As a result, the estate will not owe federal estate tax or GSTT at the death of the first spouse.

The estate of the second spouse to die will include the value of the marital trust, whether it is a Code § 2056(b)(5) trust or a QTIP trust. If the second spouse to die has little or no estate, there is neither an estate tax nor a GSTT problem. If the surviving spouse has an estate in excess of the GSTT exemption in the year of death, then that spouse's estate will claim the federal estate tax applicable exclusion amount for the estate and the GSTT exemption but will quite possibly pay GSTT on the marital deduction trust created by the first spouse. Because a marital trust is generally treated for GSTT purposes as if it were owned by the surviving spouse-not the spouse who was first to die-the surviving spouse's estate cannot take advantage of the first spouse's remaining exemption to shelter the marital trust from the GSTT. As a result, $355,000 of the first spouse's GSTT exemption has been wasted.

This common estate plan does not appear to have a latent defect. When originally designed, it may have provided for the creation of a formula credit shelter trust equal to the unified credit equivalent, with the residue of the estate passing to a marital trust. Before the spectacular stock market of the 1990s, the combined estates may have been well below the two unified credits, or the estate plan may have been drafted before the effective date of the GSTT.

QTIP Trusts

If the marital trust is a QTIP trust, the GSTT problem is more easily solved. The first spouse's estate loses the unused portion of the GSTT exemption above the unified credit equivalent unless the estate either (1) pays an estate tax on property passing in a manner that uses the remaining GSTT exemption (for example, a bequest to grandchildren) in lieu of the marital trust or (2) creates a QTIP trust and makes a reverse QTIP election under Code § 2652(a)(3). Code § 2652(a)(3), which allows the reverse QTIP election, provides as follows:

In the case of . . . any trust with respect to which a deduction is allowed to the decedent under section 2056 by reason of subsection (b)(7) [the QTIP election] . . . the estate of the decedent . . . may elect to treat all of the property in such trust for purposes of [the GSTT] as if the election to be treated as qualified terminable interest property had not been made.

By virtue of the reverse QTIP election, the first spouse to die is treated as the "transferor" of the marital trust for GSTT purposes only, which allows the trust to qualify for the marital deduction and to use the first spouse's excess GSTT exemption. Examples 3 and 6 in Treas. Reg. § 26.2652-1(a)(5) demonstrate the effect of the reverse QTIP election.

Reverse QTIP treatment requires an affirmative election on the part of the donor (in the case of a gift) or a personal representative (in the case of a decedent). Care is required to ensure the proper application of the exemption. In PLR 1999040, a husband created an otherwise valid inter vivos QTIP trust. The donor husband filed a gift tax return on which he allocated a portion of his GSTT exemption to the QTIP trust, but he did not make a reverse QTIP election. The IRS allowed the marital deduction but regarded the wife, not the donor husband, as the "transferor" for GSTT purposes. The IRS invalidated the donor husband's allocation of his GSTT exemption, but the claimed exemption was properly reinstated. This ruling emphasizes the importance of making correct and timely elections.

With an appropriately drafted document, the trustee of a QTIP trust can segregate a single trust into more than one QTIP trust. Segregating the QTIP trust allows the decedent's estate to claim the balance of the GSTT exemption using a reverse QTIP election over part, but not all, of a larger marital deduction gift. By so doing, the original decedent's estate will have successfully used all $1,030,000 of the GSTT exemption and have a zero inclusion ratio GSTT exempt marital trust. 

The chart accompanying this article depicts the estate tax and GSTT consequences of a typical estate, first with a QTIP trust and reverse QTIP election, and then with either a QTIP trust without the reverse QTIP election or a general power of appointment marital trust.

Code § 2056(b)(5) Trusts

A trust can qualify for the marital deduction under Code § 2056(b)(5), which requires the following trust provisions:

In the case of an interest in property passing from the decedent, if his surviving spouse is entitled for life to all the income from the entire interest . . . with power in the surviving spouse to appoint the entire interest . . . and with no power in any other person to appoint any part of the interest, or such specific portion, to any person other than the surviving spouse. . . .

A general power of appointment marital trust described in Code § 2056(b)(5) cannot achieve the desired GSTT result, as there is no statutory equivalent to a reverse QTIP election for a general power of appointment marital trust. The first spouse to die must be treated as the "transferor" to claim his or her remaining GSTT exemption amount of $355,000. Because the Code § 2056(b)(5) version of the marital trust would be included in the surviving spouse's gross estate on his or her death, the estate of the decedent who created the marital trust would not be able to allocate any of the decedent's GSTT exemption amount against the marital trust. Instead, the surviving spouse will be regarded as the "transferor," and only the surviving spouse's exemption could be allocated to the marital trust.

Unlike the QTIP trust, which is included in the surviving spouse's estate due to the special provisions of Code § 2044, the standard provisions of governing powers of appointment under Code § 2041 cause the inclusion of a Code § 2056(b)(5) marital trust in the surviving spouse's estate. For GSTT purposes, the IRS treats the marital trust assets as if the surviving spouse exercised the power, caused the assets to pass to his or her estate and then contributed those assets to the "family" trust created by the settlor-or in some other generation-skipping transfer. Therefore, the surviving spouse is the transferor for GSTT purposes.

Grandfathered GSTT Trusts

The rules governing Code § 2056(b)(5) marital trusts become especially problematic for trusts that were in existence before the effective date of the GSTT. One example of this issue is E. Norman Peterson Marital Trust v. Commissioner, 102 T.C. 790 (1994), aff'd, 78 F.3d 795 (2d Cir. 1996). The decedent, Mr. Peterson, died in 1974 leaving a will creating a Code § 2056(b)(5) general power of appointment marital trust for his wife's benefit. If Mrs. Peterson did not exercise her general testamentary power of appointment over the trust principal, it would pass to Mr. Peterson's grandchildren.

Mrs. Peterson died in 1987. She exercised her testamentary power only to the extent necessary to pay the estate taxes attributable to inclusion of the marital trust in her estate. The balance of the trust assets passed to Mr. Peterson's grandchildren under his will. Mrs. Peterson's personal representative included the marital trust in her gross estate and paid a GSTT of $827,404. The trustee of Mrs. Peterson's marital trust, from which the funds to pay the GSTT would come, objected to the payment.

The marital trust became irrevocable before September 25, 1985, which is the effective date for the current version of the GSTT as applied to transfers in trust. The IRS concluded that the failure to exercise a general power of appointment constituted a "constructive addition" to the trust after the September 25, 1985 effective date that resulted in imposition of the GSTT. Treas. Reg. § 26.2601-1(b)(1)(v)(A) currently defines a "constructive addition" as follows:

. . . where any portion of the trust remains in the trust after the post-September 25, 1985, release, exercise, or lapse of a power of appointment over that portion of the trust, and the release, exercise, or lapse is treated to any extent as a taxable transfer under [the gift or estate tax], the value of the entire portion of the trust subject to the power that was released, exercised, or lapsed is treated as if that portion had been withdrawn and immediately retransferred to the trust at the time of the release, exercise, or lapse. The creator of the power will be considered the transferor of the addition except to the extent that the release, exercise, or lapse of the power is treated as a taxable transfer. . . .

Noting that "addition" does not require new funds, the Tax Court held that the failure to exercise the entire general power on Mrs. Peterson's death constituted a "constructive addition" to an otherwise GSTT-exempt trust. The Tax Court cited as support Example 1 in Treas. Reg. § 26.2601-1(b)(1)(v)(D), which is nearly identical to the facts in the case before the court.

In John M. Simpson and Sarah S. Dean, Trustees of the Grover M. Simpson Testamentary Trust A v. United States, 17 F. Supp. 2d 972 (W.D. Mo. 1998), rev'd, Simpson v. United States, 183 F.3d 812 (8th Cir. 1999), the Eighth Circuit came to an opposite conclusion. Mr. Simpson died in 1966. He left assets to a Code § 2056(b)(5) general power of appointment marital trust that granted his surviving spouse a general testamentary power of appointment. Mrs. Simpson exercised the power of appointment in favor of her grandchildren in her will, which was effective when she died in 1993.

The District Court held that the effective date provision of the GSTT did not apply to the "transfer" in this case, even though the trust was created and became irrevocable before September 25, 1985. According to the district court, the "transfer," which is the "constructive addition," occurred on Mrs. Simpson's death in 1993, after the GSTT effective date. This is the same result that the Tax Court reached in Peterson.

The Eighth Circuit reversed, holding that the plain language of the effective date provision covered the transfer made by the surviving spouse's exercise of her power of appointment. Therefore, the exercise was not a transfer subject to the GSTT. This is the proper result, the court implied, because the "trust" from which the "transfer" was made was irrevocable before the 1985 effective date. Interestingly, the Eighth Circuit validated the underlying tax principle by stating that "[t]here is no dispute that the transfer in question here would be subject to the GST tax, were it not for the special effective-date rule contained in the statute, passed in 1986, that enacted the version of the GST tax effective at the time of [Mrs. Simpson's] death." Simpson, 183 F.3d at 813. At least in the Eighth Circuit, there is an argument that trusts becoming irrevocable before September 25, 1985 may not be subject to the GSTT.

Regulatory Responses

On November 18, 1999, the IRS proposed additional language to the GSTT regulations to address the problem presented in Peterson and Simpson. In the preamble to these proposed regulations, the IRS states that it sees no substantive difference between the exercise of a general power of appointment and the lapse of a general power of appointment for GSTT purposes. Additional clarifying language would be added to Treas. Reg. § 26.2601-1(b)(1)(i), which currently reads, in pertinent part, "[t]he provisions of Chapter 13 do not apply to any generation-skipping transfer under a trust (as defined in Section 2652(b)) that was irrevocable on September 25, 1985. . . ." Treas. Reg. § 26.2601-1(b)(1)(v)(A) currently provides that the lapse, release or exercise of a general power of appointment created in a pre-September 25, 1985 document is not a transfer "under the trust," but rather a transfer "by the holder" of the general power of appointment, which occurs when the exercise of the power becomes effective. The proposed regulation adds the following to the end of that sentence:

Further, the rule in the [sentence described above] does not apply to a transfer of property pursuant to the exercise, release, or lapse of a general power of appointment that is treated as a taxable transfer under [the estate or gift tax]. The transfer is made by the person holding the power at the time the exercise, release, or lapse of the power becomes effective, and is not considered a transfer under a trust that was irrevocable on September 25, 1985. . . .

The effective date of this proposed additional language is November 18, 1999.

Conclusion

Coordinating the marital deduction and the GSTT exemption can be one of an estate planner's most difficult tasks. If a QTIP trust is used, most GSTT problems can be addressed by making a reverse QTIP election. If a Code § 2056(b)(5) trust is involved, the problem can be significantly more difficult. For a taxpayer residing in an Eighth Circuit state who holds a general power of appointment over a Code § 2056(b)(5) general power of appointment marital trust created before September 25, 1985, there is an argument that the exercise or lapse of the power by the surviving spouse is neither a constructive addition nor a transfer because the effective date provision protects it. As the clarification in the new proposed regulation has not yet become final, there is some question as to whether the regulations, as amended, override the Simpson opinion. For other states, the contradiction between the Peterson and Simpson opinions causes significant ambiguity.

One who fails to address this issue runs the risk of delinquent GSTT, penalties and interest if the IRS discovers the problem during an audit of the surviving spouse's estate tax return. A taxpayer could disclose the facts to the IRS and hope to prevail with a Simpson-type defense at an estate or gift tax audit. Alternatively, the power holder could avoid the problem entirely by exercising the power in a non-generation-skipping manner.


 

Estate Tax and GSTT Consequences of a Typical Estate

PLAN WITH REVERSE QTIP

 If husband dies first
$1,030,000

And wife dies second
$1,030,000

Family Trust $675,000 

.

QTIP #1 $355,000 QTIP #2 $-0-
Family (GSTE) Trust $675,000 QTIP #1 $355,000 From Husband Family (GSTE) Trust $355,000



No estate tax due



 No GSTT



Some estate tax due on $710,000

 

No GSTT due

 
  • $675,000 + $675,000 (i.e., 2 estate tax exemptions) = $1,350,000 
  • $1,030,000 + $1,030,000 (i.e., generation skipping transfer tax exemptions for 2 estates) = $2,060,000 
  • No assumptions of estate tax equalization are made

 

OR 

PLAN WITHOUT REVERSE QTIP

Family Trust $675,000

§ 2056(b)(5) Trust

 $355,000

Family GSTE

 Trusts 

$1,030,000

§ 2056(b)(5) Trust

 $355,000 

 

No estate tax due 

No GSTT due

 

Some estate tax due 

May be GST at 55% due 

or the Code determined 

applicable percent

 

John B. Atkins