Commutation of Residuary Trust Leads to Gift Tax Liability for Decedent's Children

(Parker Tax Publishing September 2024)

The Tax Court held that the commutation of a residuary trust the property of which was treated as qualified terminable interest property (QTIP) pursuant to an election under Code Sec. 2056(b)(7), and in which the decedent's husband had an income interest and their two children had remainder interests, did not result in gift tax liability for the husband because he made no gratuitous transfers. The court further held that the commutation of the trust coupled with the transfer of the trust property in exchange for promissory notes did not result in gifts from the husband to the children, but the agreement to commute the residuary trust did result in a gift to the husband by the children under Code Sec. 2511. McDougall et al. v. Comm'r, 163 T.C. No. 5 (2024).

Background

Clotilde McDougall died in December 2011, survived by her husband Bruce and their two adult children, Linda and Peter. At that time, Clotilde's gross estate was valued at $59.76 million. Bruce served as personal representative of Clotilde's estate.

Upon Clotilde's death, the residuary of her estate passed, under the terms of her will, to a trust (residuary trust) in which Bruce had an income interest and Linda and Peter had remainder interests. Bruce elected under Code Sec. 2056(b)(7) to treat the residuary trust property as qualified terminable interest property (QTIP). In 2016, Bruce, Linda, and Peter entered into an agreement under which the residuary trust was commuted and all its assets were distributed to Bruce. Bruce promptly sold some of the assets he received from the residuary trust to other trusts established for the benefit of Linda and Peter and their children, in exchange for promissory notes.

On separate gift tax returns for 2016, Bruce, Linda, and Peter reported that the transactions described above resulted in offsetting reciprocal gifts and no gift tax. The IRS examined the returns and issued a notice of deficiency to each of Bruce, Linda, and Peter determining that (1) the commutation of the residuary trust resulted in gifts from Bruce to Linda and Peter under Code Sec. 2519 and (2) the agreement resulted in gifts from Linda and Peter to Bruce of the remainder interests in the residuary trust under Code Sec. 2511.

Bruce, Linda, and Peter all filed petitions with the Tax Court. The IRS filed a motion for partial summary judgment seeking rulings that (1) the agreement to commute the residuary trust was a disposition of Bruce's qualifying income interest under Code Sec. 2519 and resulted in gift tax liability for Bruce, (2) the agreement to commute the residuary trust resulted in gifts to Bruce by Linda and Peter under Code Sec. 2511, and (3) Bruce's deemed gift under Code Sec. 2519 and Linda's and Peter's gifts to Bruce were not offsetting reciprocal gifts. In the alternative to ruling (1), the IRS requested a ruling that the commutation coupled with the transfer of the residuary trust property in exchange for promissory notes was a disposition of Bruce's qualifying income interest under Code Sec. 2519 and resulted in gift tax liability for Bruce.

Code Sec. 2519(a) and Estate of Anenberg

Code Sec. 2519(a) provides that for estate and gift tax purposes, any disposition of all or part of a qualifying income interest for life in any QTIP is treated as a transfer of all interests in such QTIP other than the qualifying income interest.

In Estate of Anenberg, 162 T.C. No. 9 (2024), the Tax Court addressed the treatment of interests in property held in trust and designated to be treated as QTIP when Alvin Anenberg, the husband of Sally Anenberg, passed away. Following Alvin's death, Sally obtained a qualifying income interest for life, and, upon her death, the remainder interests in the corpus would contingently go to trusts for the benefit of Alvin's children. Eventually, with the consent of both Alvin's children and Sally, the trusts holding the underlying property were terminated by a state court and all the property held by the trusts was distributed to Sally, putting her in the position she would have been in if all that property had originally passed from Alvin to her. Sally later made gifts of and sold different pieces of the underlying property to Alvin's children and grandchildren. Sally passed away, leaving the gift tax consequences of these transactions to be resolved by her estate.

Sally's estate argued that the transactions just described did not result in any gift tax liability for Sally. The IRS disagreed, relying on Code Sec. 2519. The Tax Court agreed with Sally's estate and concluded that Sally made no gift. The court interpreted Code Sec. 2519 to say that, for gift and estate tax purposes, any disposition of the surviving spouse's income interest in QTIP is treated as if the surviving spouse transferred 100 percent of the remainder interests in QTIP. The court then assumed, without deciding, that the termination of the trusts through which Sally held her qualifying income interest in the QTIP and the distribution of the QTIP to Sally was a disposition under Code Sec. 2519(a).

However, the Tax Court noted that a gratuitous transfer - not just a transfer - is required to impose gift tax. The court found that no gratuitous transfer occurred because Sally's deemed transfer of the remainder interests in the QTIP held in trust (other than her qualifying income interest) resulted in her actual receipt of all the QTIP unencumbered (other than those attributable to her qualifying income interest). The court reasoned that at the end of the day, Sally gave away nothing of value as a result of the deemed transfer and therefore made no gift.

Importantly for these cases, however, while concluding that Sally made no gift, the Tax Court expressed no view on whether the other beneficiaries of the marital trust could be treated as making a gift to Sally for gift tax purposes.

Analysis

Following Estate of Anenberg, the Tax Court held that, assuming there was a transfer of property under Code Sec. 2519 when the residuary trust was commuted, Bruce was not liable for gift tax because he made no gratuitous transfers as required by Code Sec. 2501. The court also held that under Estate of Anenberg the commutation of the residuary trust coupled with the transfer of the residuary trust property in exchange for promissory notes did not result in gifts from Bruce to Linda and Peter.

The court further held that the agreement to commute the residuary trust resulted in gifts to Bruce by Linda and Peter under Code Sec. 2511. The court reasoned that under the "gratuitous transfer" framework described in Estate of Anenberg, Linda and Peter plainly made gratuitous transfers. The court reasoned that before the commutation of the trust, Linda and Peter held valuable rights, i.e., the remainder interests in the QTIP. After the commutation, which required their consent, Linda and Peter had given up those valuable rights by agreeing that all of the residuary trust assets would be transferred to Bruce. And the court noted that they received nothing in return. In the court's view, by giving up something for nothing, Linda and Peter engaged in quintessential gratuitous transfers and were therefore subject to gift tax under Code Secs. 2501 and 2511.

The court rejected the argument that Bruce, Linda, and Peter made reciprocal gifts that offset each other. That argument was based, the court observed, on the premise that the commutation of the trust resulted in a deemed gift of the remainder interest in the trust assets from Bruce to Linda and Peter under Code Sec. 2519. But the court said this premise was incorrect. The court noted that it already concluded Bruce made no gifts, and the court said that Code Sec. 2519(a) does not by its terms deem a gift; it merely deems a transfer. Thus, there were no deemed gifts from Bruce to Linda and Peter to offset the very real gifts from Linda and Peter to Bruce.

The court added that Linda and Peter never actually obtained anything of value from Bruce as a result of the commutation of the residuary trust. Under state law, they already had the remainder rights with respect to the residuary trust. And the court found that a deemed transfer under Code Sec. 2519(a) added nothing to their bundle of sticks. In other words, no matter the outcome under Code Sec. 2519(a), nothing of value passed to Linda and Peter that offset the value they gave up by relinquishing their remainder rights.

For a discussion of amounts treated as a transfer for gift tax purposes, see Parker Tax ¶222,320.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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