A series of private letter rulings over the past several years seemed to indicate that a gift to a predeceased spouse would qualify for the gift tax marital deduction and enable use of that spouse's estate tax applicable exclusion amount. In Estate of Lee, the Tax Court, stating the obvious, recently held that a bequest to a predeceased spouse does not qualify for the estate tax marital deduction. The Tax Court's decision, equally applicable in the gift tax marital deduction context, strongly suggests that practitioners would be wise to adhere to tried-and-true mechanisms for utilizing the estate tax applicable exclusion amounts of both spouses — regardless of who dies first.

Traditional Approaches

Basic estate planning for a married couple with an aggregate net worth larger than one federal estate tax applicable exclusion amount often includes taking steps to ensure that both spouses' applicable exclusion amounts are utilized to the extent necessary to cause the federal estate tax at the death of the surviving spouse is as small as possible. At the beginning of the estate-planning process, planners frequently find one spouse's net worth is a good deal larger than the other's and the other owns property worth far less than one federal estate tax applicable exclusion amount. Traditionally, the estate planner recommends in this situation that the wealthier spouse transfer to the less wealthy spouse, by inter vivos outright gift, assets with a value that likely will be sufficient to enable full use of the less wealthy spouse's applicable exclusion amount if the less wealthy spouse is the first spouse to die. Such an inter vivos gift obviously qualifies for the federal gift tax marital deduction.¹

For a variety of reasons, sometimes illogical and/or rooted in emotion, it may be impossible to convince the wealthier spouse to make a lifetime gift to the other spouse. The wealthier spouse's objections often boil down to a fear of giving the donee spouse unilateral control over the transferred property.

Occasionally, the recalcitrant spouse may be persuaded to make an inter vivos transfer to an irrevocable qualified terminable interest property (QTIP) trust. A transfer to such a trust facilitates using the less wealthy spouse's applicable exclusion amount if that spouse dies first, but the trust can be structured to confer no dispositive control on the less wealthy spouse. Moreover, depending on the provisions of the trust's governing instrument, the wealthier spouse can be the trustee without incurring adverse estate tax consequences. This approach, however, has its own set of problems, not the least of which is that an irrevocable transfer in trust is not easily recoverable if circumstances change down the road.

Siren Song

Beginning seven years ago, the Internal Revenue Service issued the first of four PLRs² that seemed to suggest there was a way to use a less wealthy spouse's applicable exclusion amount if that spouse were the first to die — without the wealthier spouse's having to transfer any property while the less wealthy spouse was living. The latest of these rulings was PLR 200604028 (issued Jan. 27, 2006).

In PLR 200604028, the wealthier spouse (S1) created and funded a revocable trust (Trust A). Under Trust A's governing instrument, S1 retained the beneficial interests and powers ordinarily held by the grantor of a revocable trust. Upon S1's death, all remaining trust property was to be distributed outright to the less wealthy spouse (S2) if S2 were then living. Any assets S2 disclaimed were to pass to a typical bypass trust. S2 was to receive the entire net income of the trust and might receive discretionary distributions of principal for S2's health, education, maintenance and support. If S2 predeceased S1, then, upon S1's death, the assets of Trust A were to be held and administered in trust for the benefit of S1 and S2's children.

The governing instrument of Trust A also provided that, if S2 were to predecease S1, S2 would possess a testamentary general power of appointment with respect to Trust A's assets having a value equal to S2's applicable exclusion amount minus the value of S2's taxable estate determined without reference to the value of Trust A's assets subject to S2's testamentary power of appointment. S2 proposed to exercise this power of appointment in favor of his own revocable trust (Trust B).

Under the terms of Trust B, S2 retained the beneficial interests and powers ordinarily possessed by the grantor of a revocable trust. At S2's death, all remaining trust property was to be distributed outright to S1 if S1 survived S2. Any assets S1 disclaimed were to pass to a credit shelter trust from which S1 was to receive the entire net income and could, at the trustee's discretion, receive discretionary distributions of principal for S1's health, education, maintenance and support. If S1 predeceased S2, then, upon S2's death, the assets of Trust B were to be held and administered in trust for the benefit of S1 and S2's children.

The IRS first ruled that, if S2 predeceases S1, S2's holding the testamentary general power of appointment will cause the value of the Trust A assets subject to the power to be included in S2's gross estate.³

The IRS next ruled that, if S2 predeceases S1, S1 will be considered to have made a gift to S2 of the Trust A assets subject to S2's testamentary general power of appointment and that such gift will qualify for the gift tax marital deduction under Internal Revenue Code Section 2523. Upon S2's death, S1 will relinquish dominion and control over the Trust A property subject to S2's testamentary power of appointment, which will result in a completed gift by S1 to S2.⁴ Presumably because S1 will retain the powers to amend Trust A's governing instrument, to revoke Trust A and to withdraw assets from Trust A, S1's conveyance of assets to Trust A will not be a completed gift.

The IRS' third ruling was that the assets passing from Trust A to Trust B by virtue of S2's exercise of the testamentary power of appointment will not be treated as a gift from S1 to the other beneficiaries of Trust B (that is to say, the children of S1 and S2.) S2, and not S1, will be treated as the recipient, owner and transferor of all assets subject to S2's power of appointment. This is the case even though S1 is in complete, unilateral control of the disposition of Trust A's assets right up until S2's death.

Finally, the IRS ruled that, if S2 predeceases S1, the value of any property passing from Trust A to Trust B that is then disclaimed by S1 will not be included in S1's gross estate. S1 will not hold a general power of appointment under IRC Section 2041 even though S1 will be the beneficiary, for life, of a credit shelter trust under Trust B. Further, the value of such property will not be includible in S1's gross estate under IRC Section 2036 because S1, not being considered the transferor of such property, cannot be treated as having made a transfer with any retained interests or rights.

Request for a Public Ruling

This series of rulings, ending with PLR 200604028, generated considerable interest and attention in the estate-planning community. Indeed, in July of 2004 shortly after PLR 200403094 was issued, Robert J. Rosepink, the then president of the American College of Trust and Estate Counsel (ACTEC), sent a letter to the IRS requesting that the Service issue a revenue ruling or other public pronouncement on which taxpayers may rely holding that: (1) property belonging to a surviving spouse that is subject to a testamentary general power of appointment held by a predeceased spouse is includable in the predeceased spouse's gross estate under IRC Section 2041; and (2) the gift made by the surviving spouse by granting the general power of appointment to the first spouse to die qualifies for the gift tax marital deduction under IRC Section 2523(a).

Almost four years later, the IRS has yet to comply with ACTEC's request. It seems that, to borrow a phrase from the immortal Jack Benny, the IRS is thinking it over.

PLRs' Achilles Heel

Perhaps the most troubling aspect of PLR 200604028 and its predecessors, notwithstanding the potential benefit to taxpayers, is the IRS' conclusion in the PLRs that, upon the death of the first spouse to die, when the testamentary general power of appointment can no longer be revoked by the surviving spouse, a gift has been made to the deceased spouse that qualifies for the gift tax marital deduction. In the PLRs, the IRS simply pronounces that a gift qualifying for the marital deduction under IRC Section 2523(a) occurs under the facts presented. No analysis of or reasoning behind this conclusion is offered.

The conclusion, though taxpayer-friendly, defies common sense. It is illogical to posit that the transfer that takes place when the testamentary general power of appointment can no longer be revoked occurs before the death of the first spouse to die for the simple reason that the power is testamentary — that is, it is exercisable only by will. It is axiomatic that a will has no legal effect whatsoever until the death of the testator. It follows, then, that the transfer that takes place when the power can no longer be revoked occurs at the death of the holder of the power — in other words, when the holder is dead and his will becomes operative. Thus, to believe that the technique seemingly blessed by the IRS in the PLRs works, one must believe that it is possible to make a completed gift to a corpse and that such gift qualifies under IRC Section 2523(a) for the gift tax marital deduction.

It's beyond dispute that not one word in IRC Section 2523(a) supports the absurd notion that a gift tax marital deduction results from a transfer from a living spouse to a dead spouse. Quite to the contrary, IRC Section 2523(a) speaks of a gift of an interest in property “to a donee who at the time of the gift is the donor's spouse.” Much as we might wish it were otherwise, a deceased spouse is manifestly not such a donee.

Apparently, the Tax Court sees it the same way. Witness its ruling on Dec. 20, 2007 in Estate of Lee v. Commissioner.⁵

Kyong Lee (the spouse) died on Aug. 15, 2001. Kwang Lee (the decedent) died on Sept. 30, 2001. The decedent's estate was substantially larger than the spouse's. Both intended that their respective estate plans achieve the maximum tax benefits available. The spouse's will contained a provision stating: “[A]ny person who shall die within six (6) months after my death shall be deemed to have predeceased me.” The decedent's will stated: “[A]ny person, other than my wife, who shall die within six (6) months after my death shall be deemed to have predeceased me … In the event that my wife shall die at the same time as I, or under circumstances such as to render it difficult or impossible to determine who died first, my wife shall be deemed to have survived me.”

The decedent's and spouse's estates were administered as if the decedent had predeceased the spouse. Under the decedent's estate plan, a marital trust was established for the benefit of the spouse as if she were still alive. The estate tax returns of the spouse and the decedent were constructed as if the decedent had died first. The decedent's estate tax return claimed the marital deduction with respect to the marital trust that was purportedly being held and administered for the spouse.

The decedent's estate argued that the decedent intended that the spouse be deemed to have survived him were he to die within six months after the spouse. The decedent's estate relied on IRC Section 2056(b)(3), which states: “For purposes of this subsection, an interest passing to the surviving spouse shall not be considered as an interest which will terminate or fail on the death of such spouse if — (A) such death will cause a termination or failure of such interest only if it occurs within a period not exceeding 6 months after the decedent's death, or only if it occurs as a result of a common disaster resulting in the death of the decedent and the surviving spouse, or only if it occurs in the case of either such event; and (B) such termination or failure does not in fact occur.” The decedent's estate concluded that this provision permits a deemed change in the order of the deaths of a husband and wife if they die within six months of each other.

In response, the Tax Court explained that “[b]y its terms, section 2056 predicates the marital deduction on the presence of a ‘surviving spouse’” and that “we read section 2056(b)(3) to permit a marital deduction even if the passing of an interest to the surviving spouse is conditioned upon the spouse's surviving the decedent by a period not exceeding 6 months, provided the spouse in fact survives the requisite 6 months.”⁶ The Tax Court also said it construes the term “surviving spouse” in accordance with its ordinary meaning; therefore, a surviving spouse must actually survive, or outlive, his or her spouse.

Because the spouse predeceased the decedent, the court concluded that the spouse cannot be considered a surviving spouse for marital deduction purposes. The Tax Court summed up by saying, “While decedent may have intended that [the spouse], even though dead, be deemed to have survived him, the operation of a will or wills cannot alter the order of the actual deaths of decedent and [the spouse].”

Be Realistic

IRC Section 2523 differs from IRC Section 2056 in that the former does not use the term “surviving spouse” but instead uses the terms “donee” and “donee spouse” to refer to the recipient of a transfer. It cannot reasonably be inferred, however, that this distinction in terminology indicates Congress' intent that a decedent's bequest must be to a living spouse to qualify for the estate tax marital deduction, but a living donor's gift can be to a dead spouse and yet qualify for the gift tax marital deduction.

This difference in the manner in which the two sections refer to a recipient spouse reflects nothing more than Congress' realization of the obvious fact that, in the estate tax marital deduction context, the recipient spouse is always a “surviving” spouse because the transferor spouse is always deceased at the time of transfer. In the gift tax marital deduction context, there could never be a “surviving” spouse but, rather, only a “donee” spouse because the transferor spouse is always living at the time of transfer.

So, while it must be acknowledged that Lee addressed the availability of an estate tax marital deduction, rather than a gift tax marital deduction, this would appear to be an immaterial distinction. In light of Lee, it is hard to imagine the Tax Court's concluding that a gift tax marital deduction would ever be available for a transfer to a spouse who is not a donee but a decedent.

There is no advantage to be obtained by a wealthier spouse's conferring on the other spouse a general power of appointment, not exercisable until the other spouse's death, with respect to any of the wealthier spouse's property if conferring the power does not qualify for the gift tax marital deduction.⁷ Even before Lee, the plain language of IRC Section 2523(a) foreclosed marital deduction treatment in connection with the transfer of an interest in property to a deceased spouse. Lee has now confirmed this conclusion. Those estate planners who may have been intrigued and enticed by the smoke-and-mirrors approach seemingly encouraged by the four PLRs should return to the undeniably effective means for ensuring that both spouses' estate tax applicable exclusion amounts are optimally utilized: judicious transfers from one spouse to the other, or from one spouse to an irrevocable QTIP trust for the other's benefit, while both spouses are alive.

Endnotes

1. Internal Revenue Code Section 2523(a).
2. Private Letter Rulings 200101021; 200210051; 200403094 and 200604028.
3. IRC Section 2041(a)(2).
4. Treasury Regulations Section 25.2511-2(b).
5. Estate of Lee v. Commissioner, T.C. Memo. 2007-371 (Dec. 20, 2007).
6. Ibid., citing Estate of Mackie v. Comm'r, 64 T.C. 308 (1975), aff'd, 545 F.2d 883 (4th Cir. 1976); and Estate of Shepherd v. Comm'r, T.C. Memo. 1989-610.
7. One might be tempted to argue that there is an advantage to be obtained if a wealthier spouse can, by conferring a testamentary general power of appointment on the other spouse, effectively divest himself of property without making a taxable gift. The theory would be that there can be no gift without a donee, and, with limited exceptions of which none is relevant here, only a living recipient can be a donee. If this argument were viable, it would, of course, make no difference whether conferring the testamentary general power of appointment generated a gift tax marital deduction, and the result would be an enormous loophole in the federal transfer tax system. For those who believe the argument has possibilities, the Brooklyn Bridge is still for sale.

Charles A. Redd is a partner in the St. Louis, Mo., office of Sonnenschein Nath & Rosenthal LLP