Unfunded Marital Trust Included in Survivor's Estate
In Olsen,1 the Tax Court addressed what portion of an unfunded credit shelter trust and marital trusts were to be included in the gross estate of the surviving spouse.
In 1994, Elwood Olsen and Grace Olsen, husband and wife, each created a separate revocable trust. The substantive terms of each revocable trust were identical. Grace Olsen died on December 9, 1998.
The terms of her revocable trust provided that upon her death, the assets of her revocable trust were to be distributed among three separate and distinct trusts - the Family Trust, Marital Trust A, and Marital Trust B. The Family Trust was to be funded with an amount equal to the federal estate tax exemption ($600,000 at the time). Marital Trust A was to be funded with the balance of the assets but not to exceed Grace Olsen's remaining generation-skipping transfer tax exemption ($1 million at the time). Any remaining assets were to be distributed to Marital Trust B.
The terms of the Family Trust provided that the trustee was authorized to distribute to Elwood income and principal of the trust for his health, education, support, and maintenance. The terms of the Family Trust also provided that Elwood possessed an inter vivos limited power of appointment in favor of charitable organizations and Grace's children and grandchildren. The terms of Marital Trust A and Marital Trust B provided that Elwood was to receive the net income of the trust, and the trustee was authorized to distribute principal of the trust for his health, education, support, and maintenance.
Elwood was the personal representative of Grace's estate. Elwood signed and filed the IRS Form 706 for Grace's estate. In that return, Elwood reported that the total value of the assets of Grace's revocable trust was $2,104,695 and that those assets were to be distributed as follows:
1. One million dollars to Marital Trust A.
2. $504,695 to Marital Trust B.
3. $600,000 to the Family Trust.
The IRS Form 706 reported a QTIP election, pursuant to Section 2056(b)(7) for Marital Trust A and Marital Trust B. However, Elwood did not, as required by the terms of Grace's revocable trust, actually segregate the assets of Grace's revocable trust into the Family Trust, Marital Trust A, and Marital Trust B.
After Grace's death, Elwood, as successor trustee of Grace's revocable trust, made two significant withdrawals from Grace's revocable trust that totaled $1.4 million. First, Elwood withdrew approximately $1 million to make a contribution to a charitable organization. Second, Elwood withdrew approximately $400,000 that he deposited into one of his accounts.
Elwood died on February 25, 2008 and his son, Ty, was the personal representative of his estate and the successor trustee of both Grace's and Elwood's revocable trusts. Following Elwood's death, Ty funded the Family Trust with the remaining assets of Grace's revocable trust based on his decision that the source of the two withdrawals of approximately $1.4 million in total was made from Marital Trust A and Marital Trust B. The IRS Form 706 filed for Elwood's estate did not include any portion of the value of Grace's revocable trust in the value of Elwood's gross estate. The IRS issued a notice of deficiency and determined that under Section 2044, the value of Elwood's gross estate should include the value of the assets of Grace's revocable trust.
Section 2044 requires the estate of a surviving spouse to include in the value of the gross estate the value of any property in which the decedent had a qualifying income interest for life if a deduction was allowed with respect to the property in the estate of the decedent's spouse by reason of Section 2056(b)(7). The parties agreed that the values of the assets of Marital Trust A and Marital Trust B were includable in the value of Elwood's gross estate under Section 2044, and that the values of any assets of the Family Trust were not includable in the value of his gross estate. However, the parties disagreed whether the distributions by Elwood from Grace's revocable trust exhausted the Family Trust or Marital Trust A and Marital Trust B.
The estate argued that all of the withdrawals from Grace's revocable trust should be treated as having come from the marital trusts based on Grace's intent, as expressed in her revocable trust agreement, to minimize estate taxes, and Elwood's duty as trustee to minimize estate taxes for the benefit of the remainder beneficiaries.
The IRS argued that the distributions from Grace's revocable trust to the charitable organization were properly appointed pursuant to Elwood's inter vivos limited power of appointment over the Family Trust in favor of charitable organizations and that the distributions to him were made pursuant to his power as trustee to distribute income and principal to him for his personal benefit.
The court held that the $1 million of withdrawals for the charitable organization should be considered to have been made from the Family Trust pursuant to Elwood's inter vivos limited power of appointment in favor of charitable organizations. However, the court held that the $400,000 of withdrawals for Elwood's benefit should be considered to have been made from the marital trusts. The court concluded that Grace did not intend for discretionary distributions of income or principal to be made from the Family Trust until the principal of the marital trusts had been exhausted.
The dispute between the estate and the IRS, and the accompanying expenses, could have been avoided if Elwood had properly funded the Family Trust and the marital trusts. Unfortunately, it is often the case that the surviving spouse treats all assets as his or hers without following the format of the estate planning instruments that were designed to save taxes. The opinion indicated that the attorney working with Elwood on the administration of Grace's estate reminded Elwood in writing on at least two occasions to fund the three trusts. That action may very well have prevented a malpractice claim against that attorney.