Gift Tax Triggered for Termination of Trust After Death – Houston Tax Attorneys

When someone sets up their estate plan, one would hope that the probate process would result in the terms of the estate plan being carried out. State law often allows beneficiaries and heirs to change the terms of someone’s estate plan after they die.

For example, in Texas, beneficiaries can usually agree to override the terms of a decedent’s will and distribute assets as they see fit. This is usually carried out using a family settlement agreement. The Texas Estates Code has been amended to include more liberal rules that allow trust beneficiaries to amend or reform the terms of trusts.

Even though state law allows for these post-mortem changes, the changes can have significant Federal tax consequences. The taxes can be significant and, in some cases, can result in the probate estate owing back taxes to the IRS. The recent McDougall v. Commissioner, 163 T.C. No. 5 provides an example. The case involves the termination of a trust by the trust beneficiaries after the trust settlor died. The termination triggered a massive gift tax liability.

Facts & Procedural History

The taxpayers in this case were a surviving spouse and his spouse’s adult children. The surviving spouse inherited an interest in a trust from his wife when she died. The interest he inherited was an income interest, so he was entitled to interest earned on the trust assets.

The children inherited remainder interests in the trust assets. These interests entitled the children to ownership of the trust assets when the surviving spouse died.

The surviving spouse was the executor of his wife’s estate. He made a QTIP election, which we’ll address below, which deferred the estate taxes that would have been due on the death of his spouse.

Several years later, the surviving spouse and children entered into an out-of-court agreement to terminate the trust and to distribute the assets to the surviving spouse. The taxpayers filed gift tax returns taking the position that there were two gifts, one from the surviving spouse on termination of the trust to children and then one from the children to transfer the assets to the surviving spouse. According to the taxpayers these transfers essentially offset each other and resulted in no gift tax due.

The IRS audited the gift tax returns, did not agree with the taxpayers reciprocal gift argument, and issued a statutory notice of deficiency. The dispute ended up in the U.S. Tax Court, which issued the tax court opinion that is the basis of this article.

About the QTIP Election

To understand this court case, we have to start with the QTIP election and the general concept for when the QTIP is used. QTIP elections typically involve trusts, so we’ll start with the QTIP trust.

A QTIP trust is one that holds some or all of the trust assets in trust for the surviving spouse. The surviving spouse has to be entitled to all of the income from the trust property and be paid at least annually. The trust also has to limit the power to appoint the property to anyone other than the surviving spouse during their lifetime.

This type of arrangement is often used to ensure that the income of the assets is used for the surviving spouse of the settlor, the person who set up the trust, with the remainder interest passing to the settlor’s children. This helps avoid a situation where assets are used for or transfered to the surviving spouse’s new spouse or the surviving spouse’s children from outside of the marriage. So second marriages and mixed families.

The QTIP election is an election made on the settlor’s estate tax return and is one of several estate tax planning considerations that one has to consider. It is similar to the GST election and tax planning in some ways. It is typically made on the estate tax return of the first spouse to die, which is usually due within 9 months of death (with a possible 6-month extension).

The election creates a legal fiction that the surviving spouse owns the trust assets when really they only have an income interest. This fiction allows the settlor’s estate to claim a 100% marital deduction for estate tax purposes. This marital deduction allows the trust assets to avoid estate tax on the death of the first spouse, which is usually not allowed when the surviving spouse does not actually have an ownership interest in the property in question and the settlor spouse retains control over who gets the property when the second spouse dies. This election and tax planning involving valuation discounts can often significantly reduce ones estate tax liability. Charitable trusts can be used for similar purposes too, if there is a charitable intent involved.

The QTIP trust is an easy way the first spouse to die can limit the surviving spouse’s ability to transfer or control the property while still qualifying for the marital deduction. Similar results can be obtained using a bypass or credit shelter trust. Other strategies usually leave the surviving spouse with some control over who gets the property on their death.

Gift Tax for the Surviving Spouse

The first question in this case was whether executing the settlement agreement to terminate the trust, the surviving spouse and children triggered a gift tax.

The U.S. Tax Court concluded that it did not, which it referenced its prior opinion in Estate of Anenberg v.
Commissioner, No. 856-21, 162 T.C. (May 20, 2024) from earlier this year. The Estate of Anenberg stands for the proposition that a surviving spouse does not make a taxable gift when a QTIP trust is terminated and all its assets are distributed to the surviving spouse. This makes sense as the marital deduction is generally allowed when property passes to the surviving spouse and the estate tax is imposed when the surviving spouse dies.

The mechanics of the actual statutes are more complex than this. This is why the U.S. Tax Court had to analyze Section 2519 so closely, and then it just applied judicial reasoning instead of a close reading and application of Section 2519. In doing so, it concluded that the surviving spouse did not give away anything of value under Section 2519 and, alternatively, that there was an incomplete gift given that the surviving spouse ended up with the assets.

Thus, in applying these principles to the current case, the tax court concluded that the surviving spouse did not make a taxable gift when the residuary trust was terminated and its assets were distributed to him. This conclusion was reached despite the fact that the termination could be viewed as, and likely was, a disposition that should trigger gift tax under Section 2519.

Gift Tax for to the Children

The tax court then turned to the question of whether the termination of the residuary trust and transfer of the assets to the surviving spouse triggered a gift tax as to the children. The tax court concluded that it did.

The reasoning here is that the children had vested remainder interests in the trust property. They gave away the right to this property by allowing the property to be transferred to the surviving spouse. Thus, when viewed before and after the transfer, the children had a decrease in their net worth. They gave something up. The tax court concluded that this was sufficient to trigger a gift tax.

The tax court did not accept the taxpayer’s arguments about a reciprocal gift which negated any gift tax. The taxpayer’s argument was that the termination of the residuary trust resulted in a taxable gift for the surviving spouse. Then it also resulted in a taxable gift for the children for the transfer back to the surviving spouse. As noted above, the tax court held that the first part of this argument–the gift tax for the surviving spouse–was not a gift and therefore did not trigger a gift tax. Thus, there could be no offsetting gift. The tax court also stated that there was no such concept as a reciprocal gift in the law that can be used to offset gift taxes. It noted that there is a concept of reciprocal trusts, but that that concept does not apply here.

To provide context, we’ll briefly take a detour to discuss reciprocal trusts. The reciprocal trust doctrine is a legal principle that addresses situations where two individuals create similar trusts for each other’s benefit. This doctrine allows the IRS and courts to “uncross” or “unwind” trusts that are interrelated and leave the grantors in approximately the same economic position as they would have been if they had created trusts naming themselves as life beneficiaries. This is similar to the economic substance doctrine that allows the IRS and/or the courts to void certain business transactions. When the IRS and/or courts apply this reciprocal trust doctrine, the result is that the trust assets are included in the settlor’s taxable estate under Sections 2036 or 2038. Again, this is not what we had in this case, so it was not applicable here according to the tax court.

The Takeaway

It is getting more common for beneficiaries of trusts to modify and even terminate their trusts. This can trigger significant tax liabilities, as in this case. This case helps to explain when the gift tax applies when one termites a trust. A QTIP trust can be terminated and this will not necessarily trigger gift taxes for the surviving spouse. If the termination results in the children getting their fair share of the trust assets, that may also avoid gift taxes. But as in this case, if the termination results in the surviving spouse getting more than what they otherwise would, the termination will likely trigger a gift tax for the children for the transfer to the surviving spouse.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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The Tax Treatment of Pre-Start-Up Costs – Houston Tax Attorneys

Can you deduct costs incurred while investigating whether to start a business? What if you spend several years researching, planning, and preparing to launch and you incurred costs during these years to do so?

Are these expenses deductible in the years before your business officially begins operations? Does the answer change if the business actually starts and is not just a start-up that never started?

The rules for “pre-start-up” businesses are not all that clear. Court cases like the recent Eason v. Commissioner, T.C. Summary Opinion 2024-17, help explain when these pre-start-up costs are deductible.

Facts & Procedural History

The taxpayer in this case, an engineer by profession, lost his job around the start of 2016. He and his spouse decided to explore various ways to earn a living.

The couple enrolled in two courses offered by a real estate investment seminar company. They paid this company $41,934 for courses in 2016.

The couple then formed a corporation on July 29, 2016, and made an election to have it taxed as an S corporation. The stated purpose of the S corporation was to provide advice and guidance to real estate owners and investors, though the specific services it intended to offer remained unclear.

Throughout 2016, the taxpayers had business cards and stationery printed and attended some training sessions related to the courses they were taking. However, by the end of 2016, no income had been generated from these activities which seems to have been because the seminar business went out of business.

On their federal income tax returns for 2016, the taxpayers claimed deductions for expenses related to the S corporation, including the cost of the education courses.

The IRS audited the taxpayers’ 2016 tax returns and concluded that the business expenses were not deductible. It denied the deductions and proposed an accuracy related penalty. This disagreement eventually led to litigation in the U.S. Tax Court.

About Section 162

Section 162 is the section that allows for a deduction for most business expenses. More specifically, it provides a tax deduction of “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” This seemingly straightforward provision has been the subject of extensive interpretation by courts and the IRS over the years.

The term “ordinary” in this context doesn’t mean common or frequent. Instead, it refers to expenses that are normal, usual, or customary in the particular business. An expense can be ordinary even if it occurs only once in a taxpayer’s lifetime. The “necessary” requirement is generally interpreted to mean appropriate and helpful for the development of the taxpayer’s business.

As relevant to this article, the statute also says that the expense has to be for “carrying on any trade or business.” This language implies that the business must already be in existence for expenses to be deductible under Section 162. Expenses incurred before a business begins operations are generally not deductible under this section.

The question of when a business officially begins “carrying on” its activities is not always clear. Courts have developed various tests and factors to determine this, including whether the taxpayer has made a firm decision to enter into business and whether they have taken substantial steps to prepare for business operations.

Start-Up Tax Rules Under Section 195

Recognizing the potential unfairness of disallowing all pre-operational expenses, Congress enacted Section 195 in 1980. This section deals specifically with start-up expenditures and provides some relief for taxpayers incurring costs before their business begins.

Under Section 195, start-up expenditures are defined as amounts paid or incurred in connection with:

Investigating the creation or acquisition of an active trade or business,
Creating an active trade or business, or
Any activity engaged in for profit before the day on which the active trade or business begins, in anticipation of such an activity becoming an active trade or business.

However, these expenses are not immediately deductible. Instead, they are treated as deferred expenses. Once the business actually begins operations, the taxpayer can elect to deduct a portion of these start-up costs (up to $5,000, reduced by the amount by which the start-up costs exceed $50,000) in the year the business begins. The remainder is amortized over a 180-month period beginning with the month in which the business starts.

It is important to note that Section 195 only applies once the business actually starts. If a planned business never comes to fruition, these rules don’t apply, and the expenses generally cannot be deducted or amortized.

When Does a Business Start for Tax Purposes?

This brings us to the very question presented by this court case. When does a business start for tax purposes? (This question is very similar to the question of when is real estate placed in service for tax purposes)

The determination of when a business begins is required for applying both Section 162 and Section 195. To understand the answer, we have to start with the Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir. 1965) case. This is a landmark court case that has been cited many many times.

In Richmond Television, the court said that a taxpayer has not “engaged in carrying on any trade or business” within the meaning of Section 162 until the business has begun to function as a going concern and performed those activities for which it was organized. The company in that case was denied deductions for staff training expenses incurred two years before it received its broadcasting license and went on air.

Like Richmond Television, the taxpayers in Eason incurred significant expenses (course fees, business formation costs) before generating any income. However, the timeline in Eason was much shorter – all within one tax year. Richmond Television involved expenses incurred several years before the business operations started.

More importantly, the critical fact in Richmond Television was when the FCC license was issued. This provided a definitive fact or event that one can point to. The Eason case did not have a definitive event like this. The court in Eason notes that there is no license required for the taxpayer’s business activities in Eason. Thus, the nature of the planned business (real estate advising) didn’t require a specific license or permit to begin operations, which would have provided an identifiable marker for when the business could have started.

Given the short time frame and the absence of an identifiable marker, the U.S. Tax Court focused on the evidence that the taxpayers had actually started providing any services by the end of 2016. The court noted that there was no evidence of this. The court completely discounted the activities of forming a corporation, taking courses, getting business cards, etc. The court simply concluded that there was no indication that the taxpayers had begun to function as a going concern or performed the activities for which their business was organized.

This decision shows that merely taking preparatory steps, even significant ones like forming a legal entity and investing in education, is not enough to be considered “carrying on” a trade or business. The court’s analysis suggests that there needs to be some actual attempt to provide services or generate income, even if unsuccessful, to cross the threshold into an active trade or business. With that said, even if the business has started, this does not mean that the expenses are deductible. The IRS can also assert that a business that has started was really a hobby and not a business at all.

The Takeaway

This case shows the type of challenges taxpayers face in deducting expenses related to new business ventures. When taking deductions for these types of expenses, taxpayers should carefully consider the timing and nature of business activities when planning to claim deductions for new ventures. This case also shows why it is important to document preparation activities in addition to actual attempts to conduct business operations. This should include steps that go beyond the steps the taxpayers took in this court case. A misstep here can result in signficant tax balances, which would no doubt mean the end of the start-up as a viable business.