Taxpayer Victory in Case Involving Termination of Marital Trust

A recent unanimous reviewed Tax Court case suggests that there may be planning options for assets stuck in a spousal qualified terminable interest property trust (“QTIP”). QTIP trusts are used often in modern estate planning because they allow the deferral of federal estate tax until the death of the surviving spouse. In Anenberg v. Commissioner, 162 T.C. 9 (May 20, 2024), the Tax Court held that the transfer to the beneficiary-spouse of all QTIP property pursuant to a court order does not trigger the gift tax. This has potentially major implications in the current planning environment.

Ideally, a spouse may wish to make a gift of some of the QTIP trust property prior to a reduction in the federal estate tax exemption amount in 2026 that will occur under current law. (The estate tax exemption will be reduced from the current amount of $13.61 million to $5 million adjusted for inflation.) This can be treacherous because of the intersection of the Tax Code and IRS regulations. In Anenberg, the surviving spouse and her children obtained a court order allowing the termination of the QTIP trust. All assets were transferred back to the spouse. The QTIP trust held valuable stock in a closely held business. The spouse waited a few months then gifted 6.4% of the stock to her stepchildren. A month later, the spouse sold all her remaining stock to the stepchildren in exchange for a promissory note. The IRS, in an audit, asserted a gift tax deficiency of $9 million and penalties of $1.8 million. The Tax Court rejected the IRS’ position and determined no gift occurred. The IRS asserted that Section 2519 of the Tax Code was applicable. Under that Code Section, a disposition of all or part of an income interest is treated as a transfer of the entire interest in the QTIP.

The Tax Court held no gift occurred upon termination of the trust because all assets came back to the spouse. The Tax Court reasoned that since the spouse owned all trust property after termination of the trust, she gave nothing away. Interestingly, the IRS did not argue “substance over form” in Anenberg as it had in previous cases. See Estate of Kite v. Commissioner, T.C. Memo 2013-43). The key takeaway from Anenberg, is that the Tax Court suggested a potential roadmap to allow a spouse to access QTIP trust assets to make gifts while the estate tax exemption is at historic levels.

Still, there are multiple risks associated with terminating a QTIP trust. First, the IRS will not make the same mistake twice: it will vigorously argue substance over form when this fact pattern again arises. Second, Anenberg did not address the argument that the stepchildren of the spouse made deemed gifts of their remainder interest when they consented to the court order terminating the QTIP Trust. This issue is currently before the Tax Court. See McDougall v. Commissioner, Docket No. 2458-22, 2459-22 and 2460-22. Aside from those arguments, there could be potential income tax consequences upon termination of the trust.