Lack of Entitlement to Current Income Doomed Marital Deduction

Generally speaking, Congress permits a free flow of assets between spouses, unencumbered by transfer taxes, via the estate tax marital deduction. A transfer to or for the benefit of a surviving spouse may qualify for the marital deduction if such interest, when retained until death, would be taxed in the surviving spouse’s estate. However, two recent developments demonstrate that unless the statutory requirements for a marital deduction are satisfied, the deduction will be denied. In Davis, 394 F3d 1294 (9th Cir. 2005), aff’g TC Memo 2003-55, the marital deduction was disallowed for a trust that restricted a surviving spouse’s right to receive all of the trust income currently. Under similar circumstances, the marital deduction was denied in IRS Letter Ruling (TAM) 200505022.

Background

Generally, under the so-called “terminable interest rule,” terminable interests do not qualify for the marital deduction; see Sec. 2056(b)(1). An exception is provided for both power of appointment trusts under Sec. 2056(b)(5) and for qualified terminable interest property (QTIP) trusts under Sec. 2056(b)(7).

Power of appointment: Under Sec. 2056(b)(5), the marital deduction is available when a surviving spouse is given both a life estate and a general power of appointment over a property interest. The surviving spouse must be entitled to all of the income from the property for life, payable at least annually, and must have the power to appoint the entire interest, or a specific portion thereof, free of trust to himself or herself or his or her estate. The surviving spouse’s power must be exercisable by him or her alone and, in all events, either during life or via a will. Lastly, no person other than the surviving spouse can have the power to appoint the property to any other person except the surviving spouse.

QTIP: A marital deduction is available for QTIP property if an election is made under Sec. 2056(b)(7), and the surviving spouse is entitled for life to all of the income from the property, payable at least annually. No person, including the surviving spouse, can have a power to appoint any part of the property to any person other than the surviving spouse.

Whiting

Qualifying for the marital deduction can be frustrated by drafting errors and inconsistencies in the operative documents. Further, local law must be interpreted to determine the nature of the interest that passes to a surviving spouse. Amply illustrating these points is Est. of Merle Allen Whiting, Jr., TC Memo 2004-68, in which a surviving spouse’s interest in a “marital deduction trust” qualified for the marital deduction, despite conflicting language in the trust document.

The court noted that the trust established for the benefit of the surviving spouse was a qualifying income interest for life. However, an “administrative provision” permitted the trustee to accumulate trust income in the event the surviving spouse became disabled, a provision that violated the Sec. 2056(b)(7) income distribution requirements. Nevertheless, the court resolved the conflict and allowed the marital deduction, noting that in interpreting conflicting clauses, the decedent’s intent must be determined “using the four corners of the trust agreement.” Thus, because the trust contained the qualifying language, despite the drafting conflict, the “[d]ecedent manifested his intent to qualify for the marital deduction in numerous ways,” including references to the marital deduction and citations to Sec. 2056 in the trust instrument.

Davis

In Davis, the Ninth Circuit agreed with the Tax Court and held that a marital deduction was not available. First, the court reviewed the nature of the interest passing to the surviving spouse under state (California) law. It noted that the trust had to be construed according to the testator’s intent; if such intent is “unambiguous from the face of the instrument,” then the trust’s plain language will govern its interpretation. The court went on to conclude that the trust document indicated that the decedent, Ralph H. Davis, intended to leave his surviving spouse, Evelyn L. Davis, a restricted income interest.

Next, the court reviewed whether the property interest bequeathed to Mrs. Davis under California law satisfied Sec. 2056(b)(7)’s marital deduction requirements. The trust, by its terms, directed that the income was to be paid to her “as the trustee, in the trustee’s reasonable discretion, shall determine to be proper for the health, education, or support, maintenance, comfort and welfare,” taking into account Mrs. Davis’ accustomed lifestyle. This restrictive language was found to be inconsistent with Sec. 2056(b)(7)’s requirement that the surviving spouse be entitled to receive all trust income currently.

The estate argued that the trust’s terms purportedly created a “general power of appointment” under Sec. 2041 that qualified it for the marital deduction. The court rejected that argument, noting that Secs. 2041 and 2056 are distinct and have different requirements. Further, the surviving spouse’s lack of requisite control over the trust income fell short of Sec. 2056’s requirements.

TAM 200505022

In the TAM, an executor elected under Sec. 2056(b)(7) to treat property passing to the surviving spouse in a trust as QTIP property, and claimed a marital deduction. The will provided that during the surviving spouse’s life, the trustee was to distribute trust income “in such amounts and at such times as my wife, in her sole discretion but in consultation with the Trustee, shall desire for her maintenance, education, health or support” consistent with her lifestyle. The trust further provided the wife access, in her sole discretion, to principal for maintenance, support, health and related needs, after taking into account all of her other sources of available income and capital, “in consultation with the Trustee.” Lastly, net income not distributed at the time of the wife’s death was to be added to the trust principal.

The Service disallowed the marital deduction. Its analysis noted that the trust’s terms denied the wife a “requisite unqualified right” to receive all the trust income annually. Distributions of income and principal were available for certain specified purposes, subject to trustee approval. The IRS viewed the trust terms to be consistent with the creation of a limited power of appointment, not a general one. Thus, neither the specific requirements of Sec. 2056(b)(5) nor (7) were satisfied.

Lastly, the Service considered the decedent’s intent. The estate argued that the decedent intended the interest to qualify for the marital deduction. It referred to correspondence between the decedent and his attorney as evidence of the former’s intent to give his wife unrestricted access to the trust assets.

However, the Service was not persuaded. It noted that the will did not refer to the estate tax marital deduction, and no other specific statement evidenced intent to qualify the trust for the marital deduction.

From Mark D. Puckett, CPA, MST, Memphis, TN