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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