An Estate And An IRA Rollover

 

Retirement accounts can create headaches with the income taxation of an estate.

We know that – if one is wealthy enough – there can be an estate tax upon death. I doubt that is a risk for most of us. The new tax bill (the One Big Beautiful …), for example, increases the lifetime estate tax exclusion to $15 million, with future increases for inflation. Double that $15 million if you are married. Yeah, even with today’s prices $30 million is pretty strong.

What we are talking about is not estate tax, however, but income tax on an estate.

How can an estate have income tax, you wonder? The concept snaps into place if you think of an estate with will-take-a-while-to-dispose assets. Let’s say that someone passes away owning the following:

·       Checking and savings accounts

·       Brokerage accounts

·       IRAs and 401(k)s

·       Real estate

·       Collectibles

The checking and savings accounts are easy to transfer to the estate beneficiaries. The brokerage accounts are a little more work - you would want to obtain date-of-death values, for example – but not much more than the bank accounts. The IRAs and 401(k)s can be easy or hard, depending on whether the decedent left a designated beneficiary. Real estate can also be easy or hard. If we are selling a principal residence, then – barring deferred maintenance or unique circumstances – it should be no more difficult than selling any other house. Change this to commercial property and you may have a different answer. For example, a presently unoccupied but dedicated structure (think a restaurant) in a smaller town might take a while to sell. And who knows about collectibles; it depends on the collectible, I suppose.

Transferring assets to beneficiaries or selling assets and transferring the cash can take time, sometimes years. The estate will have income or loss while this is happening, meaning it will file its own income tax return. In general, you do not want an estate to show taxable income (or much of it). A single individual, for example, hits the maximum tax bracket (37%) at approximately $626,000 of taxable income. An estate hits the 37% bracket at slightly less than $16 grand of taxable income. Much of planning in this area is moving income out of the estate to the beneficiaries, where hopefully it will face a lower tax rate.

IRAs and 401(k)s have a habit of blowing up the planning.

In my opinion, IRAs and 401(k)s should not even go to an estate. You probably remember designating a beneficiary when you enrolled in your 401(k) or opened an IRA. If married, your first (that is, primary) beneficiary was probably your spouse. You likely named your kids as secondary beneficiaries. Upon your death, the IRA or 401(k) will pass to the beneficiary(ies) under contract law. It happens automatically and does not need the approval – or oversight – of a probate judge.

So how does an IRA or 401(k) get into your estate for income taxation?

Easy: you never named a beneficiary.

It still surprises me – after all these years - how often this happens.

So now you have a chunk of money dropping into a taxable entity with sky-high tax rates.

And getting it out of the estate can also present issues.

Let’s look at the Ozimkoski case.

Suzanne and Thomas Ozimkoski were married. He died in 2006, leaving a simple two-page will and testament instructing that all his property (with minimal exceptions) was to go to his wife. Somewhere in there he had an IRA with Wachovia.

During probate, his son (Ozimkoski Junior) filed two petitions with the court. One was for outright revocation of his father’s will.

Upon learning of this, Wachovia immediately froze the IRA account.

Eventually Suzanne and Junior came to an agreement: she would pay him $110 grand (and a 1967 Harley), and he would go away. Junior withdrew both petitions before the probate court.

Wachovia of course needed copies: of the settlement, of probate court approval, and so on). There was one more teeny tiny thing:

… Jr had called and told a different Wachovia representative that he did not want an inherited IRA.”

What does this mean?

Easy. Unless that IRA was a Roth, somebody was going to pay tax when money came out of the account. That is the way regular IRAs work: it is not taxable now but is taxable later when someone withdraws the money.

My first thought would be to split the IRA into two accounts: one remaining with the estate and the second going to Junior.

Junior however understood that he would be taxed when he took out $110 grand. Junior did not want to pay tax: that is what “he did not want an inherited IRA” means.

It appears that Suzanne was not well-advised. She did the following: 

·       Wachovia transferred $235 grand from the estate IRA to her IRA.

·       Her IRA then distributed $141 grand to her.

·       She in turn transferred $110 grand to Junior.

Wachovia issued Form 1099-R to Suzanne for the distribution. There was no 1099-R to Junior, of course. Suzanne did not report the 1099-R because some of it went (albeit indirectly) to Junior. The IRS computers hummed and whirred, she received notices about underreporting income, and we eventually find her in Tax Court.

She argued that the $110 grand was not her money. It was Junior’s, pursuant to the settlement.

The IRS said: show me where Junior is a beneficiary of the IRA.

You don’t understand, Suzanne argued. There is something called a “conduit” IRA. That is what this was. I was the conduit to get the money to Junior.

The IRS responded: a conduit involves a trust, with Junior as the ultimate beneficiary of the trust. Is there a trust or trust agreement we can look at?

There was not, of course.

Junior received $110 grand, and the money came from the IRA, but Junior was no more a beneficiary of that IRA than you or I.

Back to general tax principles: who is taxed on an IRA distribution?

The person who receives the distribution – that is, the IRA beneficiary.

What if that person immediately transfers the distribution monies to someone else?

Barring unique circumstances – like a conduit – the transfer changes nothing. If Suzanne gave the money to her church, she would have a charitable donation. If she gave it to her kids, she might have a reportable gift. If she bought a Mercedes, then she bought an expensive personal asset. None of those scenarios keeps her from being taxed on the distribution.

Here is the Court:

What is clear from the record before the Court is that petitioner’s probate attorney failed to counsel here on the full tax ramifications of paying Mr. Ozimkoski, Jr., $110,000 from her own IRA.”

While the Court is sympathetic to petitioner’s argument, the distributions she received were from her own IRA and therefore are considered taxable income to her …”

She was liable for the taxes and inevitable penalties the IRS piled on.

Was this situation salvageable?

Not if Junior wanted $110,000 grand with no tax.

It was inevitable that someone was going to pay tax.

If Junior did not want tax, the $110 grand should be reduced by taxes that either Suzanne or the estate would pay on his behalf.

If Junior refused, then the settlement was not for $110 grand; it instead was for $110 grand plus taxes. That arrangement might have been acceptable to Suzanne, but – considering that she went to Tax Court – I don’t think it was.

The Court noted that Suzanne was laboring.

… she was overwhelmed by circumstances surrounding the will contest.”

While the Court is sympathetic to petitioner’s situation …”

Let me check on something. Yep, this is a pro se case.

Suzanne was relying on her probate attorney for tax advice. It seems clear that her attorney did not spot the issue. I would say Suzanne’s reliance on her attorney was misplaced.

Our case this time was Suzanne D. Oster Ozimkoski v Commissioner, T.C. Memo 2016-228.

An Ugly Case Over An Ugly Penalty

 

You know that the IRS pays especial attention to foreign transactions of U.S. citizens. We are to report foreign bank accounts, for example, should they exceed a certain balance.

Did you know that you may also have to report gifts made to you by individuals (and entities) overseas and exceeding certain threshold amounts?

That may come as a surprise, as we anticipate gifts to be tax free (and unreported) by the recipient. To the extent we pay attention to this area of tax, it is the donor - not the donee - who reports a gift. It is even possible to have a tax (the gift tax) if one cumulatively gifts “too much” over a lifetime.

Let’s be candid here: this is not a risk you or I have to sweat.

What got me thinking about it is a recent case coming out of California. Ms. Huang litigated over IRS penalties for her failure to timely report gifts from her overseas parents. She used TurboTax to prepare her taxes, and TurboTax advised her incorrectly about the gifts. She believes she has reasonable cause for abatement of those penalties.

I agree with her.

I also think this area of tax law is a mess.

Let’s go over this – briefly.

First, there are two considerations with foreign gifts:

·       Disclosure

·       Taxation

It is unlikely that there will be a tax, but it is likely that you must report the gift. There is even a specialized form for this – Form 3520: 

Trust me, one can have a long career in public accounting and never see this form.

The filing threshold varies depending on the donor:

Gifts From Foreign Individuals

·       The threshold is $100,000. Not surprisingly, multiple gifts from the same person (say mom) must be added together.

o   BTW, if mom gets creative and arranges to transfer more than $100 grand via various family members, there is a related party rule that will combine all those donors into one person – and put you over the $100,000 threshold.

o   Once required to file, each gift of $5 thousand or more is to be separately identified and described.

o   There may be excellent reasons for the multiple gifts. There are numerous countries which impose restrictions on outbound currency transfers. South Korea, for example, places a limit of $50,000 (USD).

Gifts From Foreign Corporations or Partnerships

·       The reporting threshold is greatly reduced if a business entity is involved – to $19,570.

·       In addition to the usual gift information, one is also to provide the name, address, and tax identification number (if such exists) for the entity.

Inheritances

The IRS takes the position that an inheritance is comparable to a gift. If one inherits from a nonresident, the inheritance might be reportable on Form 3520.

EXAMPLE: Carlos is a lawful permanent resident of the U.S. His uncle – a nonresident alien - passes away, leaving Carlos a house in a foreign country. While the residence is outside the U.S., Carlos is a U.S. permanent resident and should file a Form 3520.

Let’s change the example a little bit:

EXAMPLE: Carlos’ uncle was also a lawful permanent resident of the United States, even though he lived for substantial periods outside the U.S. The inheritance now is from one “US person for tax purposes” to another, and there is no need to file Form 3520.

  The penalties for not filing a 3520 can be onerous.

·       5% of the gift amount for each month a failure to file exists. In the spirit of not bayoneting the dead, the IRS will (fortunately) stop counting once you get to 25%.

·       If the IRS contacts you before you contact them, the penalty changes. It then becomes $10,000 for each month you fail to file Form 3520 after request.

·       Penalties will apply even if you filed a 3520, if the IRS believes that the return is incomplete or incorrect.

·       BTW this penalty can chase you unto death – and beyond. There are cases where the IRS has demanded penalties from the estates of deceased individuals.

So, what happened to Ms. Huang?

Her name is Jiaxing Huang, and in 2015 and 2016 her parents gifted substantial sums to help her relocate to the U.S. and purchase a home. Ms. Huang, like millions of others, used TurboTax to prepare her taxes for those years. She asked - and TurboTax informed her - that donors, not donees, are required to report gifts. Based on that feedback, she did not file Form 3520 for those years.

COMMENT: TurboTax was correct, IF one was talking about gifts from a U.S citizen or lawful permanent resident to another. It was not correct in specialized circumstances – such as that of Ms. Huang’s.

A couple of years later she learned of her filing obligations. Trying to play by the rules, she immediately filed Form 3520 for 2015 and 2016. She was late, of course, but she filed before the IRS ever contacted her – or had any reason to suspect that she was even required to file.

The IRS responded – here is a (too) common reason people hate the IRS – with penalties exceeding $91 grand.

COMMENT: The IRS churns these letters automatically. They do not go by human eyes. I propose – as a small improvement – that the someone at the IRS review these letters and related files before sending out such onerous penalties. I understand workforce limitations, but let’s be blunt: HOW MANY NOTICES CAN THERE BE?

Ms. Huang submitted an abatement request based on reasonable cause.

The IRS denied the request. They then withheld her 2019 ($280) and 2022 ($7,859) tax refunds.

Of course.

She appealed the denial of abatement within the IRS itself.

COMMENT: She was trying.

She instead learned that her penalty had jumped to over $153 grand. With interest she was topping $190 grand.

This was so egregious that even the IRS backed down. Appeals reduced the penalty to slightly over $36 grand.

Ms. Huang paid it.

COMMENT: No!!!!!

Two weeks later she filed a Claim for Refund.

COMMENT: Yes!!!!!

Her grounds? Abatement of the penalties – as well as the 2019 and 2022 tax refunds the IRS intercepted.

Let’s take a moment to explain why Ms. Huang paid the penalty.

In many if not most areas of tax law, one can bring suit without paying the tax (or penalty or whatever). That is one of the attractions of the Tax Court: you can get a hearing before sending the IRS a nickel. Not all areas of tax law are like this, however. An area that is not? You guessed it: Form 3520 penalties.

COMMENT: If you think about it, this is one way to keep people from bringing suit. How many can afford to pay the tax (or penalty or whatever) AND pay a tax attorney to litigate? It’s a nice scam you have there, Agent Smith.

The government did its usual: an immediate motion to dismiss the complaint. They even offered four reasons why the Court should dismiss.

The Court agreed with the government on three of the reasons.

It did not agree with the fourth: whether Ms. Huang’s reliance on tax software such as TurboTax under these circumstances could constitute reasonable cause.

Ms. Huang will have her day in Court.

But at what cost to her.

And why – when the IRS is hemorrhaging employees and losing budget allocations it likely should not have received in the first place – are they wasting their time here? The facts are unattractive. Ms. Huang is not a protestor or scofflaw. She tried. She got it wrong, but she tried. There is no win condition here for the government.

Our case this time was Jiaxing Huang v United States, Case No 24-cv-06298-RS, No District California.

Use Of Wrong Form Costs A Tax Refund

Let’s talk about the following Regulation:

26 CFR § 301.6402-2

Claims for credit or refund

(b) Grounds set forth in claim.

(1) No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim therefor except upon one or more of the grounds set forth in a claim filed before the expiration of such period. The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. The statement of the grounds and facts must be verified by a written declaration that it is made under the penalties of perjury. A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

That last sentence is critical and – potentially – punishing.

I suspect the most common “claim for refund” is an amended return. There are other ways to claim, however, depending on the tax at issue. For example, businesses requested refunds of federal payroll taxes under the employee retention credit (“ERC”) program by filing Form 941-X. You or I would (more likely) file our claim for refund on Form 1040-X. 

File a 1040-X and the tax “variance doctrine” comes into play. This means that the filing must substantially inform the IRS of the grounds and reasons that one is requesting a refund. Both parties have responsibilities in tax administration. A taxpayer must adequately apprise so the IRS can consider the request without further investigation or the time and expense of litigation.

Here is a Court on this point in Charter Co v United States:

The law requires a taxpayer “to do more than give the government a good lead based on the government’s ability to infer interconnectedness.”

Another way to say this is that the IRS is not required to go all Sherlock Holmes to figure out what you are talking about. 

Let’s look at the Shleifer case.

Scott Shleifer was a partner in an investment firm. He travelled domestically and abroad to investigate new and existing investment opportunities. Scott was not a fan of commercial airfare, so he used his personal plane. He waived off reimbursement from the partnership for his air travel.

COMMENT: Scott is different from you or me.

The Shleifers filed their 2014 joint individual tax return. Whereas it is not stated in the case, we can assume that their 2014 return was extended to October 15, 2015.

In October 2018 they filed an amended return requesting a refund of almost $1.9 million.

COMMENT: And there you have your claim. In addition, notice that the two Octobers were three years apart. Remember that the statute of limitations for amending a return is three years. Coincidence? No, no coincidence.

What drove the amended return was depreciation on the plane. The accountant put the depreciation on Schedule C. It was – in fact – the only number on the Schedule C.

In July 2020 the IRS selected the amended return for audit.

COMMENT: A refund of almost $1.9 million will do that.

The Shleifer’s accountant represented them throughout the audit.

In March 2022 the IRS denied the refund.

Why?

Look at the Schedule C header above. It refers to a profit or loss “from business.” Scott was not “in business” with his plane. It instead was his personal plane. He did not sell tickets for flights on his plane. He did not rent or lease the plane for other pilots to use. It was a personal asset, a toy if you will, and perhaps comparable to a very high-end car. Granted, he sometimes used the plane for business purposes, but it did not cease being his toy. What it wasn’t was a business.

The accountant put the depreciation on the wrong form.

As a partner, Scott would have received a Schedule K-1 from the investment partnership. The business income thereon would have been reported on his Schedule E. While the letters C and E are close together in the alphabet, these forms represent different things. For example:

·       There must be a trade or business to file a Schedule C. Lack of said trade or business is a common denominator in the “hobby loss” cases that populate tax literature.

·       A partnership must be in a trade or business to file Schedule E. A partner himself/herself does not need to be active or participating. The testing of trade or business is done at the partnership - not the partner - level.

·       A partner can and might incur expenses on behalf of a partnership. White there are requirements (it’s tax: there are always requirements), a partner might be able to show those expenses along with the Schedule K-1 numbers on his/her Schedule E. This does have the elegance of keeping the partnership numbers close together on the same form.   

After the audit went south, the accountant explained to the IRS examiner that he was now preparing, and Scott was now reporting the airplane expenses as unreimbursed partner expenses. He further commented that the arithmetic was the same whether the airplane expenses were reported on Schedule C or on Schedule E. The examiner seemed to agree, as he noted in his report that the depreciation might have been valid for 2014 if only the accountant had put the number on the correct form.

You know the matter went to litigation.

The Shleifers had several arguments, including the conversation the accountant had with the examiner (doesn’t that count for something?); that they met the substantive requirements for a depreciation deduction; and that the IRS was well aware that their claim for refund was due to depreciation on a plane.

The Court nonetheless decided in favor of the IRS.

Why?

Go back to the last sentence of Reg 301.6402-2(b)(1):

A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

The Shleifers did not file a valid refund claim that the Court could review.

Here is the Court:

Although the mistake was costly and the result is harsh …”

Yes, it was.

What do I think?

You see here the ongoing tension between complying with the technical requirements of the Code and substantially complying with its spirit and intent.

I find it hard to believe that the IRS – at some point – did not realize that the depreciation deduction related to a business in which Scott was a partner. However, did the IRS have the authority to “move” the depreciation from one form to another? Then again, they did not have to. The accountant was right: the arithmetic worked out the same. All the IRS had to do was close the file and … move on.

But the IRS also had a point. The audit of Schedule C is different from that of Schedule E. For example, we mentioned earlier that there are requirements for claiming partnership expenses paid directly by a partner. Had the examiner known this, he likely would have wanted partnership documents, such as any reimbursement policy for these expenses. Granted, the examiner may have realized this as the audit went along, but the IRS did not know this when it selected the return for audit. I personally suspect the IRS would not have audited the return had the depreciation been reported correctly as a partner expense. 

And there you have the reason for the variance doctrine: the IRS has the right to rely on taxpayer representations in performing its tax administration. The IRS would have relied on these representations when it issued a $1.9 million refund – or selected the return for audit.

What a taxpayer cannot do is play bait and switch.

Our case this time was Shleifer v United States, U.S. District Court, So District Fla, Case #24-CV-80713-Rosenberg.

A Psychiatrist, Chauffer, Physician, Peace Officer, Pheasant Hunter

 

He said that his patients often called him a psychiatrist, chauffer, physician, peace officer, or even a pheasant hunter.”

He is David Laudon, a chiropractor in Minnesota and the subject of one of the more entertaining Tax Court opinions of the last decade. Laudon, however, reached too far for too long, and he was about to learn about snapback.

Back to the Court:

But not a ghostbuster. The Commissioner rhetorically asserted that some of Laudon’s trips might have made more sense if he was claiming to be a ghostbuster. Laudon then disclaimed any employment as a ghostbuster. In his reply brief the Commissioner conceded that Laudon was not ‘employed or under contract to perform work as a ghostbuster during the tax years at issue in this case.’”

Methinks Laudon missed the joke.

How did Laudon get to court?

Easy: he was audited for years 2007 through 2009.

His records were … colorful, humorous, inadequate.

Laudon did not keep records of his income in any decipherable form.”

The IRS did a reconstruction of his business income by analyzing his bank accounts. The rule of thumb is straightforward: all deposits are income unless one can prove otherwise. A common otherwise is when a taxpayer transfers money between accounts.

Laudon contends that the Commissioner failed to classify certain deposits as nontaxable, including insurance payments for damage to several vehicles, one of which was involved in a ‘high speed police chase’ with a man ‘high on meth and cocaine.’”

There is something you do not see every day. The other thing the Court did not see was “any evidence” that the deposits were what and as Laudon described.

We therefore accept the Commissioner’s reconstruction of income.”

On to deductions.

He treats some of his patients in his home and claims to use roughly half of his house – the basement and half of the garage – for business.”

This could be a problem. Rember that an office in home deduction requires exclusive business use of the space. He claimed a lot of space, ratcheting the pressure on “exclusive.”

Like many chiropractic offices, Laudon’s has beds, tables, and a waiting area. But unlike most, his also comes equipped with a Wii, Xbox 360, big-screen TVs and, for a time, a working hair salon.”

Hair salon? What kind of chiropractic office is this?

I see that Laudon represented himself at Tax Court. I would also guess that he represented himself during the audit. Why do I say that?

We particularly disbelieve his claim that the Xbox, Wii, big-screen TVs and other electronics in his basement were used exclusively for chiropractic purposes since this claim conflicts with his much more plausible admission to the IRS examiner during audit that his daughter and his girlfriend’s son would play these video games while he was on the phone.”

There is an example of why I almost never have a client meet or speak directly with the IRS – I cannot control the exchange.

Laudon was deducting between 40,000 and 60,000 miles per year for business purposes.

.. for example, driving to a ‘schizophrenic’ patient who was – on more than one occasion – ‘running scared of demons’ down a rural Minnesota highway .…”

That last part should be incorporated into a folk or country song. I can almost hear the melody.

Laudon apparently had a penchant for adult beverages.

Laudon claimed to have driven hundreds of miles per day – sometimes without a valid license ….”

I’ll bite. What happened to his license?

Even his testimony about multiple entries in the logs where he wrote “DUI” was not credible: He claimed that these were not references to being stopped by the police while under the influence, or driving while his license was suspended .…”

Then what were they?

They “instead were his misspellings of a patient named: 'Dewey' - a supposed patient of his.'"

This is starting to read like a sit com script. I am waiting for the reference to tiger blood.

But he had a mileage log, right? Did that count for anything?

Laudon had a mileage log, but it fails to meet section 274(d)’s standards. The … entry, for example, describes his purpose as ‘travel to and from places.’”

Zen-like. Nice.

The Court also looked at other expenses, including “Other Expenses” for the three years under audit.

Most of this amount - $22,665 – was a deduction for the value of Laudon’s labor, supplies and stolen goods ….”

Wait on it.

… related to the renovation of a home that Laudon neither lived nor worked in, or even owned.”

It fits. Well done, sir.

Laudon was getting clipped on almost every deduction.

But wait.

You know the IRS wanted penalties.

Laudon asserts the defense that he reasonably relied on the advice of a tax professional.”

Yep, that is a defense, but you must use a tax professional, provide all information – good or bad – to the professional and actually rely on the professional.

Moreover, while he claimed to have brought all of his receipts to H&R Block along with his summaries, he later stated that his preparers didn’t want him to just walk in with his receipts and have them add it up ….”

Folks, accountants do not add up grocery bags of receipts. Considering that the profession usually bills based on work time, I doubt you want to pay someone for adding up your receipts.

The Court was direct:

We don’t need to address the …. because we don’t believe that Laudon provided ‘necessary and accurate information’ to his advisor.”

At this point, the Court did not believe anything Laudon was saying.

Having blinded H&R Block to the details and peculiarities of his chiropractic enterprise, Laudon cannot now claim that he relied on H&R Block’s advice. We sustain the penalty.”

Our case this time was David William Laudon v Commissioner. T.C. Summary Opinion 2015-54.

If you read only one, make it this one.

Blowing An Estate Tax Deduction

 

Let’s talk about the Estate of Martin W. Griffin.

Martin Griffin (Martin) was married to Maria Creel.

Martin created a revocable trust known as the Martin W. Griffin Trust.

COMMENT: A revocable trust means that the settlor (Martin in this case) can undo the trust. When that happens, the trust is disregarded and Martin and his revocable trust are considered the same person for tax purposes. The classic revocable trust is a “living trust,” which has no effect until one dies. Its purpose is not tax-driven at all and is instead to avoid probate.

Martin next created the MCC Irrevocable Trust.

COMMENT: Irrevocable means that Martin cannot undo the trust. He might be able to tweak a thing or two at the edges, but he cannot do away with the trust itself.

The Irrevocable Trust had the following language in the trust agreement:

The trust shall distribute the sum of Two Million Dollars ($2,000,000) to the trustee then serving …. for the benefit of Maria C. Creel. From this bequest, the trustee … shall pay to Maria C. Creel a monthly distribution, as determined by Maria and Trustee to be a reasonable amount, not to exceed $9,000 ….”

You see the word “Estate” in the case name. The issue in this case is estate tax, and it involves passing assets at death to one’s surviving spouse. There are two general ways to do this:

·       You simply transfer the asset to the surviving spouse.

An example here is a principal residence. The deed is in both spouse’s names. When you die, the house transfers directly to her (I am assuming you are the husband). She can then do what she wants: she can keep the house, sell the house, rent it or whatever. She has unfettered control over the house.

·       You transfer a right – but not all the rights – to the asset.

Let’s stay with the above example. You instead transfer a life estate to your wife. Upon her death the house goes to your children from your first marriage. She no longer has unfettered control over the asset. She cannot sell the house, for example. She has some – but not all – incidents of ownership.

The reason this is important is that the estate tax will allow you to deduct category (1) assets from your taxable estate, but category (2) assets have to go through an additional hoop to get there.

Here is the relevant Code section:

26 U.S. Code § 2056 - Bequests, etc., to surviving spouse

(7) Election with respect to life estate for surviving spouse  

(A) In general In the case of qualified terminable interest property—  

(i) for purposes of subsection (a), such property shall be treated as passing to the surviving spouse, and

(ii) for purposes of paragraph (1)(A), no part of such property shall be treated as passing to any person other than the surviving spouse.  

(B) Qualified terminable interest property defined For purposes of this paragraph—  

(i)In general The term “qualified terminable interest property” means property—

(I) which passes from the decedent,

(II) in which the surviving spouse has a qualifying income interest for life, and

(III) to which an election under this paragraph applies.

Section 2056 addresses the hoops we are talking about. If you are transferring less than total and unfettered rights to an asset, you want to make sure that you are transferring enough to qualify the asset as “qualified terminable interest property.” If you do, you get a subtraction for estate tax purposes. If you do not, there is no subtraction. 

It takes a lot to get to an estate tax in 2025 (given the lifetime exemption), but – if you do – the rate ramps to 40% rather quickly.  

Back to Martin.  

The Irrevocable Trust transferred enough to qualify as qualified terminable interest property.

Here is the Court:

The $2 million bequest is not QTIP. It is terminable interest property that does not qualify for the marital deduction and is includible in the estate.”

Huh? What happened?

Go back to (B)(iii) above:

(III) to which an election under this paragraph applies.

How do you make the election?

You include the asset on Schedule M of Form 706 (that is, the estate tax return):

That’s it. It is not complicated, but it must be done. The Code requires it.

Someone missed this while preparing Martin W Griffin’s estate tax return.

Yep, I expect a malpractice suit.