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.