In Private Letter Ruling 201834011 (released Aug. 24, 2018), the Internal Revenue Service ruled that the proposed division of a marital trust (Marital Trust) into two separate trusts—referred to as Trust 1 and Trust 2—would neither trigger income or capital gain recognition nor would it preclude either trust from qualifying for treatment as qualified terminable interest property (QTIP) trusts.
The ruling also clarified the estate and gift tax consequences of the surviving spouse’s non-qualified disclaimer of her beneficial interest in one of the two trusts created from dividing the Marital Trust.
The underlying facts in the ruling were fairly commonplace: Prior to his death, the decedent created a revocable living trust, which became irrevocable on decedent’s death. After providing for certain bequests, the underlying trust agreement provided that the remaining trust property would be held in a further trust, which would benefit the decedent’s spouse for the duration of her life. More specifically, the Marital Trust provisions mandated that all net income be distributed to the spouse, at least annually, and authorized the trustee to distribute principal to the spouse for her health, education, maintenance and support. On the spouse’s death, the trust agreement directed that any principal remaining in the Marital Trust would then be used to fund a charitable trust to be established and governed under a separate article of the trust agreement (Charitable Trust). Likewise, provisions in the Marital Trust directed that if the surviving spouse disclaimed or renounced any interest in the Marital Trust, the property so disclaimed would be added to the Charitable Trust.
The election was made on decedent’s estate tax return to treat the Marital Trust as a QTIP trust, as was authorized under the trust agreement. Thereafter, the surviving spouse—through her two children in their capacity as her co-conservators—along with the bank trustee of the Marital Trust, successfully petitioned the applicable state court for a non-pro rata division of the Marital Trust pursuant to a statutorily blessed non-judicial agreement and plan of division agreement, pending receipt of a favorable IRS ruling. Under the agreements, the Marital Trust would be divided into two separate but substantively identical trusts.
After the Marital Trust property was divided into the two Resulting Trusts, on a non-pro rata basis, it was proposed that the surviving spouse would disclaim her interest in Trust 1 while retaining her interest in Trust 2. On such a disclaimer, the trust agreement directed that the disclaimed Trust 1 property would instead be used to fund a charitable trust to be created under the trust agreement.
Six issues were raised in the ruling; namely, whether:
- the trust division would trigger ordinary or capital gain or loss recognition with respect to the Marital Trust, either Resulting Trust or any beneficiary thereof;
- the trust division would prevent the continued treatment of the Resulting Trusts as QTIP trusts;
- the deemed Internal Revenue Code Section 2519 (remainder interest) and IRC Section 2511 (income interest) gifts incident to the surviving spouse’s non-qualified disclaimer of her beneficial interests in Trust 1 would qualify for the gift tax charitable deduction;
- IRC Section 2044(a) would cause the value of the surviving spouse’s deemed Section 2519 gift of Trust 1’s remainder to be included in surviving spouse’s gross estate;
- surviving spouse’s non-qualified disclaimer of all beneficial interests in Trust 1 (Renunciation) would trigger an additional deemed Section 2519 gift from her with respect to Trust 2’s remainder; and
- the Renunciation would cause surviving spouse’s interest in Trust 2 to be valued at zero under IRC Section 2702.
Gain or Loss Recognition
With respect to the first issue raised, the ruling held that the proposed transfer of assets from the Marital Trust to the two Resulting Trusts wouldn’t trigger gain or loss recognition for income tax purposes because: (1) the beneficiaries held all of their interests in the Marital Trust’s assets through the Resulting Trusts, the terms of which remained identical both before and after the division; and (2) a partition of jointly-owned property is neither a sale nor other disposition of property when its co-owners severed their joint interests without acquiring any new or additional interests, as was true in the case at hand.
Treatment As QTIP Trusts
The ruling held that the division of the Marital Trust into the Resulting Trusts—Trusts 1 and 2—wouldn’t disqualify the Resulting Trusts from continued treatment as QTIP trusts because the terms of the Resulting Trusts mirrored the terms of the Marital Trust, and the surviving spouse would continue to have a qualifying lifetime income interest in the Resulting Trusts, as she had with respect to the Marital Trust before the trust division.
Gift Tax Charitable Deduction
Before discussing the ruling as to the third issue, a brief discussion of Sections 2511 and 2519 may be helpful. A special (and perhaps non-intuitive) gift tax rule applies to a disposition by the donee-spouse of her interest in property that was the subject of a prior QTIP gift to her from her spouse. Even though the donee spouse has only a life estate in the property, if she makes a gift (or non-qualified disclaimer, which is treated like a gift) of her income interest, then she’s deemed to have made a gift of the entire property. This rule is intended to maintain the integrity of the IRC’s inter-spousal transfer tax theory of tax deferral, rather than tax forgiveness. Sections 2519 and 2044 accomplish the goal of taxing the entire property through the gift tax and the estate tax systems, respectively. Those unaware of Section 2519 will be unhappily surprised to find that what would seem to be a gift of only an income interest (which is subject to gift tax pursuant to Section 2511) is actually a gift of the entire value of the property (pursuant to Sections 2511 and 2519).
With that in mind, the ruling addressed the third issue by holding that the deemed Section 2519 (remainder interest) and Section 2511 (income interest) gifts, which were triggered by surviving spouse’s non-qualified disclaimer of her interests in Trust 1, qualified for the gift tax charitable deduction because the trust agreement directed that any disclaimed Marital Trust interests would pass to a charitable trust created under the trust agreement that was presumably qualified as a tax-exempt charitable organization. Therefore, the entire value of Trust 1, which the surviving spouse was deemed to have transferred by gift under Sections 2519 and 2511, passed to a qualified charitable recipient under the trust agreement and thereby gave rise to a concomitant gift tax charitable deduction for the surviving spouse.
Inclusion in Gross Estate
The ruling noted that although Section 2044(a) provides that an individual’s gross estate includes any lifetime income interest property received from one’s spouse in a manner that qualified for the estate or gift tax marital deduction, Section 2044(b) prevents estate inclusion to the extent that the recipient-spouse was deemed to have gifted such property under Section 2519. Therefore, the ruling held that Section 2044(a) wouldn’t trigger estate inclusion for the surviving spouse to the extent of the remainder value of Trust 1 (that is, the Trust 1 property that surviving spouse was deemed to have gifted under Section 2519), which makes sense because the surviving spouse’s estate would account for that amount on its estate tax return (if applicable) as part of the surviving spouse’s lifetime taxable gifts.
Additional Deemed Gift
The ruling held that although the surviving spouse’s renunciation of her entire interest in Trust 1 triggered the concomitant deemed gifts equal to her income interest (under Section 2511) and the remainder value (under Section 2519) of Trust 1, it wouldn’t trigger any deemed gifts with respect to Trust 2 because the Resulting Trusts were to be treated as two separate and distinct trusts at all times on and after the trust division. In sum, the surviving spouse’s renunciation of her interest in Trust 1 wouldn’t affect Trust 2 because Trust 2 was to be established, funded and respected as a separate trust; apart and distinct from Trust 1 for all purposes.
Effect of Renunciation
The ruling built on its resolution of the fourth and fifth issues in holding that the Renunciation wouldn’t cause the surviving spouse’s continuing interest in Trust 2 to be valued at zero under Section 2702 because the two Resulting Trusts were to be analyzed as truly separate trusts. As a result, the surviving spouse’s post-Renunciation interest in Trust 2 couldn’t be fairly described as a “retained” interest with respect to the transferred Trust 1 assets because the two Resulting Trusts were to be separately analyzed and the surviving spouse held no post-Renunciation interest in Trust 1.
Though the ruling is decidedly favorable to taxpayers, it serves as a reminder of the potential perils and uncertainty that remains in the trust division and modification context.
Stephen Putnoki-Higgins is an attorney in the trusts and estates group at Shutts & Bowen LLP, in Tampa, Florida, and is admitted to practice in Connecticut, Florida, and New York.