A recent Private Letter Ruling (“PLR”) issued by the IRS highlighted the importance of a properly prepared Form 706 Estate (and Generation Skipping Transfer) Tax Return (“706”).[1] The PLR granted the requesting Estate a 120-day extension to make a QTIP election (discussed below) as well as divide the QTIP Trust into a Generation Skipping Transfer (“GST”) Exempt Trust and a GST Nonexempt Trust and make a corresponding “Reverse QTIP” election (also discussed below).[2] The Estate did timely file the 706 at issue, however, certain mistakes were made which resulted in the failure to properly make the required QTIP election and also the Reverse QTIP election allocating GST Exemption.
In the present case, based on the facts in the PLR, the Estate was a taxable estate (i.e. the assets in the decedent’s gross estate were in excess of the decedent’s remaining estate tax exemption at death). The decedent’s estate plan, utilizing a revocable trust, was a formula bequest of the remaining exemption amount to a Bypass Trust, with the excess passing to a QTIP Trust intended to qualify for the marital deduction under Section 2056. A formula bequest can take a number of different structures, and in the present case, it appears to have been a pecuniary marital formula. Ultimately, this formula leaves the minimum amount necessary to avoid the payment of federal estate tax to the marital deduction share, which in this case happened to pass to a QTIP Trust. To illustrate with numbers, let’s assume the decedent died in 2022 when the estate tax exemption is $12.06M, had not used any exemption during life, and had a $30M estate. The Bypass Trust would receive $12.06M, and the QTIP Trust would receive $17.94M (ignoring administration expenses, fees, etc.).
QTIP Trusts and Making the QTIP Election
Section 2056 of the Internal Revenue Code provides for an unlimited marital deduction for estate tax purposes for property that passes to a surviving spouse. However, such property must pass in a manner that is not a terminable interest in order to qualify for the marital deduction.[3] In simple terms, a terminable interest is an interest “which will terminate or fail on the lapse of time or on the occurrence or the failure to occur of some contingency.”[4] Generally, a trust is considered a terminable interest. Something that passes outright to the spouse is not.
Fortunately, Section 2056(b)(7) allows property passing in trust to qualify for the marital deduction as long as it is Qualified Terminable Interest Property (“QTIP”), hence the term that is often used, a QTIP Trust. While there are other forms of trusts that qualify for the marital deduction, mainly under Section 2056(b)(5), it is safe to say that the term “Marital Trust” most often refers to a QTIP Trust.
A QTIP trust must meet all the requirements under Section 2056(b)(7) in order for property passing to such Trust to qualify for the marital deduction. Among those requirements are that the surviving spouse must have a qualifying income interest for life[5], the surviving spouse must be the sole beneficiary[6], the surviving spouse must have certain rights regarding the holdings of the Trust[7], and the QTIP election must be made on a 706[8].
In the present case, the initial 706 failed to make the QTIP election though all the other requirements were met for a valid QTIP Trust.[9] The QTIP election is made on Schedule M of the 706, the Schedule where bequests to surviving spouses are listed. On Schedule M, there are two boxes to lists assets, the first, Box, A, is for “QTIP property”, and the second, Box B, is for “All other property”. Making the QTIP election is as simple as listing the assets passing to the QTIP Trust in Box A of the Schedule M. Unfortunately for the Estate in the present case, the return preparer failed to do so and instead listed all property under Box B of the Schedule M, thereby failing to make the required QTIP election for all the property passing to the Trust. The result is that none of the property passing to the QTIP Trust qualified for the marital deduction, and thus was subject to estate tax on whatever passed to the QTIP Trust since the decedent’s exemption had already been used on assets passing to the Bypass Trust. Luckily for the tax return preparer and the Estate, the IRS granted the requested relief allowing the Estate to file a Supplemental Form 706 and correct the mistake by listing the property in Box A of Schedule M and thereby making the QTIP election.
The Reverse QTIP Election
In a perfect world, since the estate tax exemption and the GST exemption are equal prior to either one being used during life, the Bypass Trust in this case would use up all of the estate tax exemption and all of the GST exemption and would be fully exempt from GST tax. There would be no need to sever trusts into GST Exempt and GST Nonexempt or for a complicated “Reverse QTIP” election. However, for a variety of reasons, many taxpayers who make lifetime gifts end up with a discrepancy between their remaining estate tax exemption at death and their remaining GST exemption at death, even though both numbers started out the same. One common scenario that creates the discrepancy where the estate tax exemption is more than the GST exemption at death is gifts to a so called Crummey Trust, since gifts to a Crummey Trust qualify for the annual exclusion for gift tax purposes[10] but not for GST purposes[11] unless the Trust is a specially drafted Trust known as a Section 2642(c) Trust, which most dynasty type multi-generational trusts are not.[12] The result is that a gift to a Crummey Trust typically uses more GST exemption than it does gift and estate tax exemption. If this were the fact pattern in the present case, the Bypass Trust, not the Marital Trust, would be divided into Exempt and Nonexempt Trusts.
Based on the fact that here, the Marital Trust was divided into Exempt and Nonexempt Trusts, we can deduce that the decedent had more GST exemption at death than he or she did estate tax exemption. This typically occurs when lifetime gifts are made to Non-Skip Persons[13]. These gifts use estate and gift tax exemption, but not GST exemption. At death, the decedent is left with more GST exemption than estate tax exemption. This is what occurred in the present case. When this is the case, if there is a QTIP Trust, the surviving spouse would typically become the Transferor for GST purposes at his or her subsequent death,[14] since a QTIP Trust is included in the surviving spouse’s estate at death. This could result in unused GST exemption from the original decedent. Luckily, an election referred to as a “Reverse QTIP” election can be made to allow the decedent to allocate GST exemption to a QTIP Trust even though, absent the election, the decedent would not ultimately be the Transferor of the property in the QTIP Trust.[15] A Reverse QTIP election must be made for 100% of the property in the Trust,[16] hence one of the reasons that the PLR also requested, and was granted, an extension of time to divide the QTIP Trust into an Exempt Trust and a Nonexempt Trust, the other being the sometimes difficult administration of a Trust that is only partially GST Exempt.
GST exemption is allocated on Schedule R of the 706 and the Reverse QTIP election must be made on the 706[17], with the Schedule R being the mechanism for making such election. Note that there are automatic allocations rules found in Section 2632, sometimes referred to as the dumb-but-lucky rules, but such does not apply to automatically make a Reverse QTIP election. In the present case, the preparer of the 706 did not file a Schedule R at all. Likely, the result of this was automatic allocation to the Bypass Trust under Section 2632, depending on the terms of the Trust, with the remaining unused exemption lost. Luckily, as with the failure to properly make the QTIP election, this error was also discovered. In the PLR, the decedent’s Estate was granted a 120-day extension to sever the QTIP Trust into an Exempt Trust and a Nonexempt Trust, and file a Schedule R to make the Reverse QTIP election.
Take-Away
The 706 is a complicated tax return with a myriad of traps for the unwary. Due to the large exemption amount we currently have, not near as many 706s are filed as were prior to the Tax Cut and Jobs Act of 2017, and really prior to the American Taxpayer Relief Act of 2012. Accordingly, many professionals are not as well versed in the 706 as they used to be. Given the importance of the 706 and the disastrous consequences in terms of estate and GST tax that can occur where an election is missed on the 706, practitioners and clients alike should pay extra careful attention when a 706 is required to be filed. In addition to missed elections and missed GST allocations, the 706 also serves as the estate’s “opening position,” if you will, in an eventual audit from the IRS, a common occurrence in a large taxable estate. Ultimately, the Estate in the present case was able to avoid disastrous consequences through the relief granted in the PLR, but that was not doubt a costly and timely endeavor to obtain the PLR, and I’m sure certain folks out there were sweating pretty hard during the interim of the discovery of the error and the favorable PLR.
[1] PLR 202242002. See also, IRS Form 706 at https://www.irs.gov/pub/irs-pdf/f706.pdf.
[2] Id.
[3] §2056(b).
[4] Treas. Reg. §20.2056(b)-1(b).
[5] §2056(b)(7)(B)(i)(II).
[6] §2056(b)(7)(B)(ii).
[7] Treas. Reg. §20.2056(b)-7(d), citing to Treas. Reg. §20.2056-5(f).
[8] §2056(b)(7)(B)(v).
[9] This appears to be the case based on the facts, though on this issue, the ruling was limited to granting a 120 extension to file a Supplemental 706 and make the QTIP election.
[10] Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968); §2503(b).
[11] §2642(c)(2).
[12] Id. A §2642(c) trust requires a single beneficiary, and estate inclusion in said beneficiaries estate, among other requirements. Due to the estate inclusion, it does not fit the bill for a standard multi-generational dynasty type trust.
[13] §2613(b).
[14] 2652(a)(1)(A), see §2652 in general for the definition of a “Transferor”.
[15] §2652(c)(3). Note that, while the surviving spouse is still living, the decedent would still be the Transferor regardless of whether this election is made, but then would cease to be the Transferor at the surviving spouse’s subsequent death.
[16] Treas. Reg. §26.2652-2(a).
[17] §2652(c)(3).
