Estate Includes Gift Tax on Net Gift of QTIP Income Interest
Estate of Morgens, 109 AFTR 2d 2012-2006, 678 F3d 769, 2012-1 USTC ¶60645 (CA-9, 2012).
In Estate of Morgens, 1 the Ninth Circuit held that gift taxes paid by the remainder beneficiaries of a QTIP trust as a result of a gift by a surviving spouse of the income interest in the trust must be included in the gross estate of the surviving spouse if he or she dies within three years of the gift.
Mr. and Mrs. Morgens executed a joint revocable trust. On the death of Mr. Morgens, one-half of the property in the revocable trust was distributed to the residual trust and the other half was distributed to the survivor's trust. The residual trust was for the benefit of Mrs. Morgens and provided that she was entitled to the income from the trust for life. The residual trust provided that on the death of Mrs. Morgens, the assets remaining in the trust were to be divided into equal shares for the children and grandchildren of Mr. and Mrs. Morgens.
The estate of Mr. Morgens filed an estate tax return and claimed a marital deduction for the assets passing to the residual trust because the trust satisfied the requirement of a QTIP trust in Section 2057(b)(7). Shortly after the estate tax return was filed, the residual trust was divided into two trusts. Mrs. Morgens retained a right to the income from both trusts.
In December 2000, Mrs. Morgens relinquished her lifetime income interest in Residual Trust A, and in January 2001, Mrs. Morgens relinquished her lifetime income interest in Residual Trust B. Pursuant to Section 2519(a), the gift by Mrs. Morgens of her income interest in Residual Trust A and Residual Trust B resulted in a deemed gift by Mrs. Morgens of the remainder interest in the trusts to the remainder beneficiaries. Mrs. Morgens filed a gift tax return reporting the gifts of the income interest and the deemed gift of the remainder interest.
As part of the 2000 and 2001 gifts, the remainder beneficiaries of the residual trusts entered into an indemnification agreement with Mrs. Morgens pursuant to which the remainder beneficiaries agreed to indemnify Mrs. Morgens for any gift taxes that may be imposed as a result of the gifts by Mrs. Morgens of her interests in the trusts. Therefore, the gifts by Mrs. Morgens were “net gifts” because the trustees of the residual trusts paid the gift taxes associated with such gifts.
Mrs. Morgens died in 2002 within three years of both her 2000 and 2001 gifts. The estate of Mrs. Morgens filed an estate tax return. The IRS determined a deficiency on the basis that Section 2035(b) required the estate to include in the gross estate of Mrs. Morgens the gift
taxes paid as a result of her gifts of the income interests and the deemed gifts of the remainder interests. The estate had not included in the gross estate of Mrs. Morgens such gift taxes. The estate filed a petition in Tax Court, the Tax Court held in favor of the IRS, and the estate appealed to the Ninth Circuit.
The issue in this case involved the interrelationship between Sections 2035(b) and 2207A(b). The court began its analysis by considering Section 2035(b). Section 2035(b), referred to as the “gross-up rule,” provides that the gross estate includes any gift taxes paid by the decedent or the decedent's estate on any gift made by the decedent or his or her spouse during the three-year period preceding the decedent's death. The estate argued that Section 2035(b) was not applicable because the trustees of the residual trusts, not Mrs. Morgens, paid the gift taxes due as a result of her gift.
The court rejected the estate's argument relying on the case of Sachs. 2 In Sachs, Mr. Sachs gave stock to three irrevocable trusts established for the benefit of his grandchildren. The donation was structured as a “net gift” because the transfer documents required the trusts to pay any gifts taxes. Mr. Sacks died within three years of the gift, but the estate did not report on the estate tax return the gift taxes paid by the trusts. The IRS issued a notice of deficiency based on Section 2035(b). The Tax Court agreed with the IRS, and the estate appealed to the Ninth Circuit.
The Ninth Circuit upheld the decision of the Tax Court and ruled in favor of the IRS, stating "the fact that the Internal Revenue Service received the payment for the decedent's gift tax liability via the donee does not make it any less a tax paid by the decedent or his estate within the meaning of Section 2035(b)." The court in the Morgens case, agreed with the analysis used in the Sachs case in concluding that gift taxes paid by a donee within three years of the donor's death under a net gift arrangement are nevertheless deemed paid by the donor for purposes of Section 2035(b) and therefore must be included in the donor's gross estate.
The court found the net gift analogy persuasive to a QTIP transfer because, as in a net gift, the financial responsibility for the gift taxes on a QTIP transfer rests on the donee rather than the donor, even though the shift occurs by contract in a net gift and by the operation of Section 2207A in a QTIP transfer. However, as in a net gift, the actual liability for the gift taxes remains with the donor.
Section 2207A(b) provides that if a gift tax is due on the transfer of an interest in a QTIP trust, the surviving spouse is allowed to recover from the recipients of the QTIP property the gift taxes paid by the donor. The court found unpersuasive the estate's argument that Section 2207A demonstrates congressional intent to shift to the donee the tax liability for the gift tax resulting from the QTIP transfer. The court found that the estate's argument was foreclosed by the plain language of Section 2207A. The court stated that the language of Section 2207A does not provide that the tax liability is transferred from the donor to the donee in the case of a QTIP transfer. Rather, Section 2207A states that the donor, who is liable for the tax, may recover the amount of the tax paid from the beneficiary of the deemed transfer. Therefore, having rejected each of the estate's arguments, the court concluded by holding that the gift taxes paid by the residual trusts as a result of Mrs. Morgen's gifts must be included in her gross estate.
The Morgens case reminds practitioners to consider the applicability of Section 2035(b) in all gift transactions—especially in those transaction involving net gifts and transfers of interest in QTIP trusts where the gift taxes are paid by the donor.
1 109 AFTR 2d 2012-2006, 678 F3d 769, 2012-1 USTC ¶60645 (CA-9, 2012).
2 62 AFTR 2d 88-6000, 856 F2d 1158, 88-2 USTC ¶13781 (CA-8, 1988).
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more about QTIP trusts, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the October 2012 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.