Portability on a QTIP Only Estate Tax Return

New Ruling

The IRS has just issued Revenue Procedure 2016-49 to provide assurance to taxpayers about an issue that many have pondered.

A Bit of Background: QTIP

Historically, a married couple avoided federal estate tax on the first death, and minimized federal estate tax overall, by using a common two pronged approach. First, assets up to the federal estate tax exemption amount, $5 million inflation adjusted ($5,450,000 in 2016) to a trust that the surviving spouse could benefit from but which was not included in her estate. The remainder of the estate over that amount would be bequeathed in a manner that qualified for the estate tax marital deduction. To protect the surviving spouse from predators and to assure that the intended remainder beneficiaries (e.g., children from the first spouse’s prior marriage) received the inheritance on the death of the surviving new spouse, this bequest that qualified for the marital deduction would be made into a special marital trust called a “QTIP.” This stands for qualified terminable interest property trust. The surviving spouse could be the only beneficiary during her lifetime and had to receive income distributed at least annually. This type of trust qualified for marital deduction treatment by the executor electing to treat it in this manner under Code Section 2056(b)(7).

A Bit of Background: Portability

Another concept needs to be understood as well, “portability.”

Portability is the right of an executor to transfer or “port” the unused estate tax exemption from the first spouse to die to the second spouse to die. This is called the deceased spouse’s unused exemption or “DSUE.” That can be a rather substantial tax benefit and alone can enable most married Americans that would be subject to an estate tax without this rule, to avoid estate tax with little other planning. In the past, before portability became law, the first spouse to die had to transfer assets to a trust that let the surviving spouse benefit but which kept those assets out of the surviving spouse’s estate. This trust was known by many names: credit shelter trust, applicable exclusion trust or bypass trust. Now the estate of the first spouse can elect to port the unused exemption to the surviving spouse without the need for a special trust. This election is made under Code Section 2010(c)(5)(A).

Relationship of QTIP Election and Portability

Since bequests to the credit shelter trust are taxable (unlike bequests to the marital deduction QTIP Trust) they use up exemption of the first spouse. This reduces the amount of exemption that can be ported to the surviving spouse. Conversely, a QTIP election would reduce the deceased spouse’s taxable estate and thereby maximize the amount of unused exclusion available to be used by the decedent’s surviving spouse. In other words, the bigger the marital deduction the more of the exemption would remain to port to the surviving spouse.

Thus, the executor of an estate electing portability of the decedent’s unused applicable exclusion amount (deceased spousal unused exclusion amount, or DSUE amount) may wish to make a QTIP election without regard to whether the QTIP election is necessary to reduce the estate tax liability to zero.

Example: Husband dies with $2 million estate. There is no need to make a QTIP election (i.e., to qualify the estate for the estate tax marital deduction) because there will be no estate tax on a $2 million estate (assuming that most of husband’s exemption was not used before he died for gifts). Nonetheless, the executor of husband’s estate might wish to make a QTIP election on the entirety of the $2 million since by qualifying the entirety of the estate for the marital deduction the surviving wife can preserve the entirety of the husband’s $5 million inflation adjusted exemption. The surviving wife might wish to do this “just in case.” She might worry that a future Congress might reduce the exemption amount and that this might preserve (grandfather) it. She might have substantial assets in her own name. Alternatively, which is more fun to contemplate, she might wish to augment/maximize her exemption so that she can use it to entice a new husband to marry her to gain that benefit (since a wealthy new husband could use her exemption on a gift tax return to protect gifts of his wealth to his children from a prior marriage).

Old QTIP Ruling Created Angst

Once upon a time, long long ago, before “portability” became part of the estate planners’ lexicon, the IRS issued a ruling to help taxpayers. Perhaps taxpayers and advisers have been skeptical that the IRS would just be a nice guy, so advisers worried about how that old “nice IRS” ruling might interact with the new concept of portability.

Rev. Proc. 2001-38, 2001-24 I.R.B. 1335, provides a procedure by which the IRS will disregard and treat as a nullity for federal estate, gift, and generation-skipping transfer tax purposes a QTIP election made in cases where the election was not necessary to reduce the estate tax liability to zero.

Example: Husband died with a $2 million estate when the estate tax exemption was $2 million. The husband’s executor, confused by the complexity of the estate tax rules, meant to treat the trust that these assets passed to as a bypass trust. That result would have removed the assets from the surviving wife’s estate, avoided tax on husband’s death (since the $2 million in this credit shelter trust would avoid estate tax as a result of husband’s $2 million exemption). But the executor did a booboo and instead elected under Code Section 2056(b)(7) to treat what was supposed to be a credit shelter trust as a QTIP trust. Oh my! If this happened that $2 million would be included in the surviving spouse’s estate. Code Section 2044(a). The husband’s exemption would be wasted. Shades of malpractice!

So the nice folks at the IRS suggested “no harm, no foul” in Revenue Procedure 2001-38 and saved the day. The nice IRS provided relief to the surviving spouse of a decedent whose estate received no benefit from the unnecessary QTIP election.  In simpler English the unnecessary and undesired QTIP election could be ignored.

So now that we live in a portable world (and you thought only laptops were portable) what happens? A different type of tax planning is now desired as explained earlier. So voiding a QTIP trust that is not necessary to reduce estate taxes (which was desirable under pre-portability law) could have a detrimental instead of a positive impact.

Worrywart Tax Advisers

Clients want dysfunctional tax advisers that worry about fictional tax-Chimera. With millions at stake the more their advisers worry the better the client sleeps. So worry we all did. Advisers fretted over whether the procedure to void and nullify QTIP elections provided as a kind gesture by the IRS in Revenue Procedure 2001-38 going to make it questionable as to whether a taxpayer living in a portable world could make an otherwise unnecessary QTIP election to maximize the available unused estate tax exclusion amount, i.e., to maximize the DSUE.

More Kindness from the IRS

The IRS, in the new Revenue Procedure 2016-49 modifies and supersedes Rev. Proc. 2001-38 to eliminate this one worry of tax practitioners (but don’t be concerned we’ll all find other technicalities to obsess over). The new Revenue Procedure confirms the process by which the IRS will disregard a QTIP election, but it excludes from its scope those estates in which the executor made the portability election in accordance with the regulations under § 2010(c)(5)(A).

The IRS explained that when the old Revenue Procedure 2001-38 was issued (specifically, before the availability of portability), an unnecessary QTIP election produced adverse tax consequences and no benefit for taxpayers.  That Revenue Procedure provided relief by treating the unnecessary QTIP election as void. This leniency was offered because an executor would never purposefully elect QTIP treatment for property if the election was not necessary to reduce the decedent’s estate tax liability.” Under prior law that was almost assuredly the case. But were now in a brave new estate tax world. Portability might result in the executor of the first deceased spouse’s estate wanting to elect QTIP treatment for property even where the election is not necessary to reduce the estate tax liability. As explained above, a QTIP election could reduce the amount of the taxable estate preserving more of the deceased spouse’s exemption (applicable credit amount) generating a greater DSUE than had no QTIP election been made.

The IRS indicated that it will continue to provide procedures by which it will disregard an unnecessary QTIP election and treat such election as void, but only for estates in which the executor neither made nor was considered to have made the portability election.  In estates in which the executor made the portability election, QTIP elections will not be treated as void.

When Will a QTIP Election Be Treated as Void

The revenue procedure treats as void QTIP elections made in cases where all of the following requirements are satisfied:

   (1)  The estate’s federal estate tax liability was zero, regardless of the QTIP election, based on values as finally determined for federal estate tax purposes, thus making the QTIP election unnecessary to reduce the federal estate tax liability;

(2)  The executor of the estate neither made nor was considered to have made the portability election as provided in § 2010(c)(5)(A) and the regulations thereunder; and

What are the consequences if the QTIP election is treated as void? The property for which the QTIP election is disregarded will not be includible in the gross estate of the surviving spouse under Code Sec. 2044, and the spouse will not be treated as making a gift under Code Sec. 2519 if the spouse disposes of part or all of the income interest with respect to the property.  Finally, the surviving spouse will not be treated as the transferor of the property for generation-skipping transfer tax purposes under Code Sec. 2652(a).

When Will a QTIP Election Not be treated as Void

A QTIP election won’t be treated as void if:

(1)  A partial QTIP election was required with respect to a trust to reduce the estate tax liability and the executor made the election with respect to more trust property than was necessary to reduce the estate tax liability to zero;

(2)  A QTIP election was stated in terms of a formula designed to reduce the estate tax to zero. Treasury Regulation Sec. 20.2056(b)-7(h), Examples 7 and 8;

(3)  The QTIP election was a protective election under Treasury Regulation Sec. 20.2056(b)-7(c); and

(4)  The executor of the estate made a portability election.

How to Void A QTIP

The taxpayer has to submit the information required by the new Revenue Procedure with a supplemental Form 706 filed for the estate of the deceased spouse, a Form 709 (United States Gift Tax Return filed by the surviving spouse, or (c) a Form 706 filed for the estate of the surviving spouse.  The following statement should be written on the top of the tax form “Filed pursuant to Revenue Procedure 2016-49.”  The return must identify the QTIP election that should be treated as void and explain why the QTIP election is within the scope of this Revenue Procedure.  The explanation should include all the relevant facts, including the value of the predeceased spouse’s taxable estate without regard to the allowance of the marital deduction for the QTIP at issue compared to the applicable exclusion amount in effect for the year of the predeceased spouse’s death.  The explanation should state that the portability election was not made in the predeceased spouse’s estate and include the relevant facts to support this statement.   Evidence sufficient to establish that the QTIP election was not necessary to reduce the estate tax liability to zero based on values as finally determined for federal estate tax purposes and that the executor opted not to elect portability of the DSUE amount may include a copy of the predeceased spouse’s estate tax return filed with the IRS.

What Does it all Mean?

Any uncertainty as to whether a QTIP election could be made when there was no reduction in estate tax has been eliminated. The IRS has given clear guidance as to what can be done to void a QTIP election when that remains appropriate.