Although most estate planners regard qualifying for the marital deduction as a fundamental technique, every year there are several cases, letter rulings and revenue rulings in which the IRS challenges the availability of the marital deduction. This article reviews the marital deduction provisions and the terminable interest rule, makes drafting suggestions and analyzes some recent cases and rulings to illustrate possible pitfalls in drafting for the marital deduction.
The Terminable Interest Rule
Property passing to the surviving spouse outright is generally not subject to taxation at the death of the first spouse because of the unlimited marital deduction provided by Section 2056 of the Internal Revenue Code. But a decedent could leave the property in trust for the surviving spouse's benefit, rather than bequeath the property outright to the spouse. Assets held in trust for a surviving spouse may qualify for the marital deduction if the terms of the trust comply with the requirements of Code § 2056 and the spouse's interest does not violate the terminable interest rule.
Code § 2056 defines a "terminable interest" as an interest in property (1) that will lapse or terminate on the occurrence or nonoccurrence of an event or on the lapse of time; (2) that will pass to someone other than the surviving spouse for less than adequate and full consideration on the failure of the interest of the surviving spouse; and (3) that is such that the person to whom the property passes will be able to enjoy or possess the property after the failure of the surviving spouse's interest.
The classic example of a terminable interest is the gift of property to a surviving spouse in trust with the remainder to children-the spouse's interest in the trust property terminates on the occurrence of an event (the spouse's death); that interest passes to someone other than the surviving spouse (the children); and the person to whom the property passes will be able to enjoy the property after the failure of the surviving spouse's interest.
A terminable interest will not qualify for the marital deduction unless it fits within a statutory exception. The marital deduction is a deferral, not a forgiveness, of tax. If tax is not paid on property at the first spouse's death because of the marital deduction, then the surviving spouse's estate must include that property. The surviving spouse's estate will pay the transfer tax on the property for which the marital deduction was taken. The terminable interest rule prevents the possibility that property giving rise to a marital deduction in the first spouse's estate is not subsequently excluded from the surviving spouse's estate, thereby escaping transfer tax altogether.
For example, assume that a decedent leaves assets for the surviving spouse in trust, the terms of which do not qualify for any exception to the terminable interest rule. In the absence of the terminable interest rule, the decedent's estate would take a marital deduction for the value of the property left in trust for the surviving spouse. On the surviving spouse's death, the spouse's estate would report only the life estate the surviving spouse held at death, which by definition would now be valued as zero. Thus the property left in trust for the spouse would escape taxation entirely.
Terminable Interest Rule Exceptions
A terminable interest does not violate the purpose of the marital deduction-deferral of tax until the death of the surviving spouse-if the Code otherwise provides that the property giving rise to the marital deduction is included in the surviving spouse's estate. Code § 2056 enumerates a number of terminable interests that will qualify for the marital deduction if properly structured, including the qualified terminable interest property (QTIP) trust in Code § 2056(b)(7), the power of appointment trust in Code § 2056(b)(5) and the six month survival exception in Code § 2056 (b)(3). All of the exceptions to the terminable interest rule are creatures of statute. The IRS and the courts will demand that the taxpayer strictly comply with the terms of the applicable statutory exceptions in order to qualify for the marital deduction.
The "Wait and See" QTIP
One example of the IRS' strict reading of the statutory exceptions to the terminable interest rule involves the "wait and see" (or contingent) QTIP. In certain circumstances, a client may wish to give the executor the power to decide which property will fund a trust for the surviving spouse by qualifying that property for the marital deduction with a QTIP election. The IRS attacked these "wait and see" QTIPs as violating the terminable interest rule in Estate of Clack, 106 T.C. 131 (1996); Estate of Spencer, 43 F.3d 226 (6th Cir. 1995); Estate of Robertson, 15 F.3d 779 (8th Cir. 1994); and Estate of Clayton, 976 F.2d 1486 (5th Cir. 1992).
The IRS took the position in each case that the executor's power to affect the amount of property funding the QTIP trust equaled a power of appointment to the decedent's other beneficiaries. Because of this power, the trust was a terminable interest not meeting the statutory QTIP trust exception requirements and therefore did not qualify for the marital deduction. In each case, the courts disagreed with the IRS and allowed the deduction. Each court stated that the purpose of the QTIP trust exception to the terminable interest rule is not to ensure that the property will go to the surviving spouse but rather to ensure that the property will be subject to tax in one of the spouse's estates.
A power to appoint property away from the surviving spouse defeats the purpose of the terminable interest rule, because the property escapes tax in both estates. By contrast, the "wait and see" QTIP does not violate the purpose of the rule, because the fiduciary must include in the first spouse's estate any property for which QTIP treatment was not elected. After the Tax Court's ruling in Clack, the IRS finally acquiesced in each case and adopted Temp. Reg. § 20.2056(b)-7T(d)(3)(ii), which authorizes the use of the "wait and see" QTIP.
To avoid potential marital deduction problems, a lawyer drafting estate planning documents should carefully consider whether the plan's provisions will satisfy the requirements of Code § 2056. Use of precise language can avoid questions of ambiguity. Savings clauses (e.g., "I intend that the property shall qualify for the marital deduction") clarify issues of the testator's intent and can empower a fiduciary to correct any technical or interpretive issues. Several form books provide standard language that will comply with the marital deduction rules.
If the client wants to vary the standard language to place unusual conditions or restrictions on a bequest, the terminable interest rule should be carefully considered. Before deviating from standard marital deduction provisions, a lawyer must always ask, "Does this condition create a terminable interest?" If the condition potentially violates the terminable interest rule, the lawyer should advise the client in writing of the potential adverse tax effects if the IRS challenges the marital deduction. If the client still wants to give the property subject to conditions that may disqualify the marital deduction, at least the client is making an informed decision. Memorializing this advice in writing may save the lawyer from a malpractice claim if estate taxes become due on property that did not qualify for the marital deduction.
Estate of Rinaldi
Estate of Rinaldi, 38 Fed. Cl. 341 (1997), illustrates the dangers of inadvertently creating a terminable interest. In Rinaldi, the decedent's will created a QTIP trust but allowed the decedent's son to purchase the stock of the family corporation from the QTIP trust at book value. At the time, the fair market value of the stock was $1.5 million and the book value was $1.39 million. The IRS argued that this "bargain sale" was the equivalent of a power of appointment of property away from the surviving spouse for less than full and adequate consideration. After the decedent's death, the company redeemed the stock held in trust for fair market value in order to preserve the company's S corporation status. The estate argued that the redemption of the shares cured the ineligibility, since the shares were no longer subject to purchase by the son for less than fair market value.
The court examined the "wait and see" QTIP cases, all of which allowed the marital deduction. As discussed above, the "wait and see" QTIPs did not violate the purpose of the terminable interest rule, since the first spouse's estate included all property for which no QTIP election was made.
By contrast, the Rinaldi trust was at all times subject to being depleted by the son's exercise of the "bargain sale" provision, which would effectively appoint property away from the spouse. The first spouse's estate would take a marital deduction for the fair market value of the company's stock, but the surviving spouse's estate would include only proceeds of the sale equal to the book value of the stock. Therefore, property with a value equal to the difference between the fair market value and the book value of the stock could escape taxation. Although the trust no longer owned the stock at the time of the QTIP election, the court noted that there was nothing to prevent the trust from reacquiring the shares, which would again be subject to the bargain sale provisions.
No matter how remote this situation might be, it is the "possibility, not the probability, that an interest will terminate" that is the determining factor. The court concluded that "the achievement of the purposes of the marital deduction is dependent to a great degree upon the careful drafting of wills." In allowing marital deductions for property subject to the terminable interest rule, Congress "chose a technique which required the draftsman of testamentary instruments to be meticulous in adhering to the formal requirements" of Code § 2056. The court ruled in favor of the IRS, holding that the trust was a terminable interest that did not qualify for the statutory QTIP trust exception. The denial of the marital deduction caused an estate tax deficiency of almost $400,000 plus interest.
The Roels Case
In Roels v. United States, 928 F. Supp. 812 (E.D. Wisc. 1996), the decedent left his entire estate to a trust for the benefit of his surviving spouse. On the surviving spouse's death or remarriage, the trust property would pass to charity. The trust did not qualify as a charitable remainder trust because the spouse's income interest did not take the form of an annuity or unitrust payment. Although the property could pass only to the surviving spouse or charity, the court held the estate liable for a tax of over $350,000. Because the spouse's interest in the trust would lapse upon remarriage, the trust was a terminable interest that did not fit into any of the statutory exceptions. It might have been possible to reform the trust to qualify as a charitable remainder trust, but the fiduciary would have had to commence a reformation proceeding within 90 days after the required filing date of the estate tax return, including extensions. If no estate tax return were due, the deadline would have been 90 days after the trust's income tax was due, including extensions.
In both Rinaldi and Roels, the decedents' desired estate plans inadvertently created terminable interests at very little gain. In Rinaldi, the bargain sale provisions would have saved the son only about $100,000, a small discount compared to the value of the stock ($1.5 million). Because of this small potential bargain, the entire $1.5 million in stock was subject to estate tax on the first death. All of the property in the Roels case passed to either the surviving spouse or a charity, so no tax should have been due. Because the remarriage clause ran afoul of the marital deduction rules, the estate incurred a tax of over $350,000.
These cases demonstrate the importance of carefully examining even the most seemingly inconsequential restriction or power over property for which the executor will claim a marital deduction. The drafting lawyer should be certain to recognize issues, advise the client of the potential problems and assist the client in making an intelligent, informed decision about the requested conditions.
Reforming the Will in Probate Court
Faced with a will that does not comply with the marital deduction rules, many lawyers ask the local probate court to reform the document. The probate court probably will not object to the reformation if all of the beneficiaries agree. It is no surprise that these requests are often granted.
Problem solved-until the IRS ignores the probate court's reformation based on Commissioner v. Bosch, 387 U.S. 456 (1967). Bosch holds that a federal court is not bound by a decision of a state court in determining federal tax laws, unless it is a decision of the state's highest court. If the federal court believes that the probate court's decision does not follow the ruling of the state's highest court, the federal court need not follow the decision. Interestingly, the Bosch case also involved the qualification for the marital deduction.
In Estate of Rapp, 140 F.3d 1211 (9th Cir. 1998), the decedent left property in trust for the life of the surviving spouse. The trust gave the children, as co-trustees, the power to distribute amounts of principal and income as they determined necessary for the surviving spouse's health, education and support. Because the terms of the trust did not require the trustees to distribute any income to the spouse, the trust did not meet the QTIP trust exception to the terminable interest rule and did not qualify for the marital deduction.
Mrs. Rapp asked the probate court to modify the will in order to qualify the trust as a QTIP trust. It does not appear that this request was opposed by the children, who were, in all likelihood, interested in deferring the tax and not interested in taking property away from their mother. The probate court in California granted the petition and modified the will so that the trust would qualify as a QTIP trust. Citing Bosch, the IRS determined that it was not bound by the probate court decision and disallowed the marital deduction.
The Rapp decision emphasizes the fact that the wills were drafted by a lawyer who was not an "estate attorney." Although the lawyer who drafted the wills did not testify at the probate court proceeding, he did testify at the government's behest before the Tax Court. The lawyer indicated that the decedent intended to create a trust for the children's benefit and did not want to leave property outright to Mrs. Rapp. The Tax Court concluded that the will was not ambiguous and that there was little or no evidence to suggest that the decedent intended to create a QTIP trust.
Perhaps Mr. Rapp was truly more concerned with the children than his surviving spouse and never intended to create a bequest that would qualify for the marital deduction. But the drafting lawyer would have been wise to explain in writing that the estate taxes could have been deferred if certain changes had been made and to memorialize that the client made his decision after being fully informed on the tax effects.
The Six Month Survival Contingency
A bequest that is contingent on the spouse's survival for a period of time is a terminable interest. Code § 2056 (b)(3) permits a survival contingency if the survival period is no longer than six months (although, to avoid confusion, a testamentary document should define six months as 180 days). Two recent cases involved dispositions to a surviving spouse that were contingent on the spouse surviving the distribution of the estate. In both cases, the clause "survive distribution" failed the requirements of Code § 2056(b)(3) because the survival period could last beyond six months. In Estate of Heim, 914 F.2d 1322 (9th Cir. 1990), the court concluded that it was irrelevant that Mrs. Heim actually survived distribution. The fact that the survival period could extend beyond six months created a terminable interest that did not fit into the Code § 2056 (b)(3) exception.
The estate argued that Section 1036 of the California Probate Code overrode the provisions of the will and saved the marital deduction. California Probate Code § 1036 provides that any survivorship requirement applicable to a marital deduction gift is automatically limited to the permissible six month period. Because the court found no evidence that the decedent intended the gift to qualify for the marital deduction, the gift was not a "marital deduction gift" and not saved by the statute.
Estate of Bond, 104 T.C. 652 (1995), also involved a bequest contingent on surviving distribution. The Washington Probate Code section at issue in Bond contained the same provision limiting marital deduction gifts to a six month survival period that was at issue in Heim. See Wash. Rev. Code Ann. § 11.108.660. Relying on Heim, the Tax Court concluded that the statute did not override the will's survivorship requirement, since there was insufficient evidence that the decedent intended the gift to qualify for the marital deduction. All was not lost, however, since the Tax Court also held that the estate's real property was not subject to the will's survival period because real property under Washington law vested in Mrs. Bond immediately upon her husband's death. Therefore, at least the real property in Bond qualified for the marital deduction.
Use of a Savings Clause
Drafters should consider using a savings clause, such as the following:
I intend that the Marital Trust shall qualify for the federal estate tax marital deduction. This document shall be interpreted and all powers and discretion given shall be exercised in a manner consistent with the rules and regulations regarding the federal estate tax marital deduction.
This clause could prove the decedent's intent to qualify a gift for the marital deduction and make a stronger case for a reformation that would be respected by the IRS. In both Heim and Bond, the court found no proof of the decedent's intent to qualify the gift for the marital deduction. If a savings clause had been used, the court might have had sufficient evidence of intent to allow the marital deduction.
The IRS does not automatically accept a savings clause, and courts do not always uphold them. In Estate of Walsh, 110 T.C. 393 (1998), the surviving spouse's right to receive income or appoint the property lapsed upon incompetency. The trust agreement stated that "it is our intention that TRUST A shall qualify for the marital deduction under the federal estate tax provisions of the Internal Revenue Code . . . [T]he provisions shall be so construed and questions pertaining to TRUST A shall be resolved accordingly." The trust agreement also provided that a principal purpose of the trust was to provide for subsistence for the surviving spouse during competency and thereafter to allow the spouse to qualify for medical assistance at minimal family expense. Because the property could be appointed to someone other than the surviving spouse during her lifetime, these provisions violated the terminable interest rule.
The estate argued that the intent of the trust was to qualify for the marital deduction and therefore the testator's intent should govern. But the trust also had the inconsistent stated intent to avoid medical expense upon incompetency. Therefore, the estate could not successfully argue that a probate court could reform the trust to qualify for the marital deduction, despite the savings clause.
Fortunately, the courts and sometimes even the IRS will not disallow the marital deduction if a scrivener's error frustrates the testator's intent to create a marital deduction gift. In these cases, the courts must determine whether the testator intended the gift to qualify for the marital deduction. In these cases, a savings clause would be particularly helpful, especially if it is apparent that there was an honest mistake in the drafting.
In Miller v. United States, 949 F. Supp. 544 (N.D. Ohio 1995), the court allowed the marital deduction despite a scrivener's error that made a spendthrift clause apply to the marital deduction trust. In 1973, the Millers' lawyer drafted a will with a boilerplate spendthrift clause. This clause contained a provision that limited its applicability to the non-marital (or "B") trust. In 1982, the same lawyer updated the wills to take advantage of the new, unlimited marital deduction. In updating the wills, the nonmarital trust was changed to the "A" trust and vice versa, and the sentence that made the spendthrift clause applicable only to the nonmarital trust was omitted. If the spendthrift clause applied to the marital trust, it could not qualify for the marital deduction.
In allowing the marital deduction, several maxims of interpretation of testamentary documents guided the court. Most importantly, the court should construe a document in accordance with the testator's intent. If possible, a will should be construed within its four corners. A construction that would make an entire clause superfluous should be avoided. Finally, a court should assume that the testator intended to comply with controlling law. Because the testator's intent could not be determined from the four corners of the will, the court looked to extrinsic evidence to determine that the intent was to create a QTIP trust that would have succeeded but for a scrivener's error. The lawyer admitted that he was inattentive in the "flip-flopping" of the trusts between A and B and the omission of the one sentence. But the court found that this was an inadvertent change attributable to "the gremlins" inherent in repeated word processing revisions and unclear, handwritten, editorial marks. The court concluded that the Ohio State Supreme Court, if asked, would have reformed the will to comply with the QTIP regulations, and therefore the marital deduction was allowed.
Miller provides an important lesson: a lawyer should exercise special care when working with forms, since any change in one part of the document might have unexpected consequences in another portion. It is also instructive to compare Miller with Rapp to understand the situations in which a reformation will be respected. In Miller, the scrivener's error was an obvious mistake and the testator's intent to create a marital deduction gift was clear. Although the testator in Rapp may have wanted a marital deduction gift, there was no evidence to suggest this, and therefore the reformation was not respected. It is more likely that reformation will be allowed if the testator's intent is clear. Although a savings clause may not cure all defects, it should assist in proving intent in some cases.
Qualifying property for the marital deduction should not be difficult, but with simplicity comes a tendency to overlook the obvious. A drafting lawyer should always consider whether the terms of a testamentary document comply with the requirements of Code § 2056. A drafter should be aware of the traps and pitfalls associated with the terminable interest rule. One should always use precise language, especially when dealing with statutory exceptions. Most importantly, a lawyer should explain to the client any potential problems in qualifying for the marital deduction. A careful practitioner will put this explanation in writing and let the client make an informed decision.
John J. McCreesh IV is an attorney with McCreesh, McCreesh, McCreesh and Cannon in Upper Darby, Pennsylvania