Understanding and Manipulating Estate and Gift Taxes – Part II

As an Estate Planning practitioner, I always considers the impact that estate, gift, generation-skipping transfer, and inheritance taxes will have on an Estate Plan. After all, clients frequently inquire about tax impact during consultation and beneficiaries usually wonder not only if taxes will result from their inheritance but also who will bear the burden of paying said taxes. Generally, the individual making the gift bears the responsibility of paying any taxes on the transfer during life or at death. The first part in this two-part series Understanding and Manipulating Estate and Gift Taxes focused on understanding the basics of the Estate and Gift Tax. This second part will explore one sanctioned way to manipulate the Estate and Gift Tax.

The Internal Revenue Code (“Code”) levies an estate tax on the value of the assets of an estate exceeding the Applicable Exclusion Amount (“AEA”) at the rate of 40%. In 2023, each U.S. citizen / resident has an AEA of $12.92 million, meaning that an individual can transfer up to $12.92 million either during life or at death without worrying about incurring a gift or estate tax on the transfer. For those whose estates exceed the AEA, Code Section 2056 offers relief in the form of an unlimited deduction for property other than terminable interest property passing to the surviving spouse. Again, the Code provides a save for even terminable interest property if it meets the requirements of Code Section 2056(b)(7) – the “Qualified Terminable Interest Property” (“QTIP”) Trust. To receive the unlimited marital deduction for property passing to a surviving spouse through a properly structured QTIP Trust, the decedent’s fiduciary needs to file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return and elect QTIP treatment thereon. That election comes at a price though because it forces inclusion of the value of the QTIP Trust in the surviving spouse’s estate at the surviving spouse’s death, pursuant to Code Section 2044.

The surviving spouse’s estate bears the burden of paying tax on those assets, notwithstanding that the surviving spouse cannot control ultimate disposition of those assets. The decedent spouse can decide what happens to those assets upon the death of the surviving spouse. Further, the QTIP Trust need not include any distributions of principal to the surviving spouse, yet the Code includes that principal amount in the surviving spouse’s estate. Thankfully, the Code contains some balance. Code Section 2207A allows the decedent spouse’s estate the right to recover the amount by which inclusion of the QTIP Trust in the surviving spouse’s estate increased the total taxes due on the surviving spouse’s estate.

Let’s return to our example from last week. If you recall, Howard and Bernadette each had an estate of $25 million. Howard structured his plan to create a Family Trust with his remaining AEA, let’s assume that it was $12.92 million because he died in 2023 with his AEA intact. The remainder ($12.08 million) went into a Marital Trust for Bernie’s benefit. Let’s change the facts such that Bernie’s trust qualified for the QTIP election, thereby resulting in no taxes due upon Howard’s death. Now, let’s assume that Bernadette dies in 2023 without having used any of her AEA. She, too, has $12.92 million that she can shield from estate taxes. The $12.08 million remainder of her estate will be subject to tax at a rate of 40%, resulting in a tax liability of $4,832,000 ($12.08 *.40) …but wait! We forgot to include the principal of the QTIP Trust in our calculation of tax for Bernadette’s estate. Thus, Bernie’s estate would total $24.16 million ($25 million plus $12.08 million QTIP less $12.92 AEA) resulting in a total tax liability of $9,664,000 ($24.16 * .40). Not such a great result for her beneficiaries since they will not benefit from the assets in the QTIP Trust. Code Section 2207A, however, changes that result and allows Bernadette’s estate to recover the $4,832,000 amount by which the taxes increased because of inclusion of the value of the QTIP Trust in her estate. Thus, Bernie’s beneficiaries do not bear the burden of taxes on property from which they do not benefit and her estate recovers from the person or persons receiving the property that was included in Bernadette’s estate. This right to recover provides a more equitable result for Bernie’s beneficiaries who are in the same position as if Bernie never benefitted from the QTIP Trust.

Treasury Regulation Section 20.2207A-1(a)(1) explains that the recovery is from the “person receiving the property.” Thus, in our example, if Howard’s kids, Halley and Neil, received the QTIP Trust upon Bernie’s death, Bernadette’s estate could recover from the children. Let’s change the facts such that Halley and Neil were the children of both Howard and Bernadette. In that case, perhaps Bernadette’s fiduciary has no concerns about recovery because the beneficiaries are the same. Code Section 2207A(a)(2) allows a waiver of the right of recovery in either the Will or the Trust of the surviving spouse. This waiver allows the surviving spouse to determine whether their estate should recover any resulting taxes or whether the estate should forego such recovery.

If the beneficiaries of the QTIP Trust are the same as the surviving spouse’s beneficiaries, it’s more tax efficient for the surviving spouse to waive the right of recovery. If the statute of limitations for the estate to recover from the beneficiaries based upon the surviving spouse’s estate’s statutory rights under Code Section 2207A expires, then that results in a gift, likely unintended.