I. Introduction

A Qualified Terminable Interest Property (“QTIP”) trust is a type of trust often used to provide for a surviving spouse while allowing the decedent to control the ultimate distribution of assets following the surviving spouse’s death. A QTIP trust can provide significant benefits, such as deferral of the estate tax, flexibility in asset distribution and control over distributions.

However, the assets remaining in a QTIP trust at the surviving spouse’s estate will be included in the surviving spouse’s estate and subject to federal and/or state estate tax at the surviving spouse’s death. Depending on the size of the surviving spouse’s estate, it may be desirable for the surviving spouse to use alternative estate planning techniques to reduce the estate tax burden. Additionally, non-tax considerations, such as substantial long-term health care expenses of a beneficiary, or disputes between current and remainder beneficiaries, may arise and make the unwinding of a QTIP Trust a desirable option.

When remainder beneficiaries and a surviving spouse are in agreement, the question arises: what is the most effective method for terminating a QTIP trust? The simplest approach is for the trustee of the trust to make distributions to the surviving spouse pursuant to the terms of the trust. However, if the trust’s distribution standard is too limited, or the trust does not permit any distributions of principal to the spouse, a surviving spouse may desire to formally terminate the QTIP trust. Whether motivated by tax planning or non-tax considerations, such a termination could lead to unintended tax consequences.

This article will examine the consequences of the termination of QTIP trusts in recent Tax Court cases. Specifically, this article will discuss the Tax Court’s opinions in the Estate of Anenberg v. Commissioner[1] and McDougall v. Commissioner[2] and discuss practical implications for estate planners.

II. Mechanics of QTIP Trusts

Federal law provides an unlimited marital deduction to allow spouses to transfer assets to each other without gift or estate tax liability.[3]  In general, this does not apply to trusts for the surviving spouse’s benefit. However, a QTIP Trust is a type of trust that qualifies for the federal estate tax marital deduction if certain conditions are met. This allows a couple to defer the payment of estate tax until the second death. To be considered a QTIP trust under Internal Revenue Service (“IRS”) regulations, all income (interest, dividends, etc.) generated on the assets of the QTIP trust must be paid to the surviving spouse (at least annually) for his or her lifetime.[4]  In addition, no one may have a power to appoint the property to anyone other than the surviving spouse during his or her lifetime.[5]  If these two criteria are met, then the surviving spouse has a “qualified income interest for life.”  In addition, the surviving spouse must have the right to convert non-income producing property into income-producing property.[6]

To take advantage of the benefits of a QTIP trust, the executor of the deceased spouse must make a QTIP election on the federal estate tax return (Form 706). Once the QTIP election is made, the surviving spouse is considered the deemed owner of the property for transfer tax purposes under IRC Sections 2044 and 2519.[7]

In his presentation entitled “Not Too Rich, Not Too Poor: Transferring Wealth for the Middle Rich,” Robert K. Kirkland makes the following observation: “A QTIP election is at root a “deal” between the surviving spouse and the government. The government allows a marital deduction, and the surviving spouse agrees that all the enjoyment and value of the property as to which the election is made will flow through the hands of the surviving spouse. The “deal” is necessary because a QTIP trust often is designed without any other power in the surviving spouse which would cause estate tax inclusion.”[8]

Upon the death of the surviving spouse, the QTIP trust assets are included in the estate of the surviving spouse, and any estate tax is calculated on the amount remaining in the trust. However, the assets in the QTIP trust at the surviving spouse’s death pass to the beneficiaries designated by the deceased spouse. This arrangement allows for the deceased spouse to retain control over the disposition of assets remaining at the second death.

This type of trust is frequently used in blended families. When spouses have children from prior marriages, they can provide for their current spouse but also ensure that any remaining assets pass to their own children. In other situations, spouses may prefer to pass on their own assets to different beneficiaries.

III. Gift Tax Issues Upon Trust Commutation or Termination

When a QTIP trust is commuted (where income and remainder beneficiaries receive their actuarial shares) or terminated during the surviving spouse’s lifetime, complex gift tax consequences can arise. These scenarios are governed primarily by IRC Section 2519, which addresses transfers that effectively diminish the surviving spouse’s qualifying income interest. Unlike straightforward lifetime gifts, dispositions involving QTIP trusts carry the risk of triggering substantial deemed gifts of the entire trust corpus, excluding only the retained income interest (which is subject to gift tax under IRC Section 2511). This portion examines how the IRS treats such events, emphasizing the importance of careful planning to avoid unintended tax liabilities.

IRC Section 2501 imposes a tax on the transfer of property by gift made during a transferor’s lifetime. IRC Section 2519 is a provision of the tax code that prevents a surviving spouse from transferring his or her interest in a QTIP trust in a manner that would circumvent the federal gift and estate tax system.

As previously mentioned, in a QTIP trust, a surviving spouse must have a “qualifying income interest for life.”  Treasury Regs. Section 25.2519-1(a), states that

“if a donee spouse makes a disposition of all or part of a qualifying income interest for life in any property for which a deduction was allowed under Section 2056(b)(7) or Section 2523(f) for the transfer creating the qualifying income interest, the donee spouse is treated…as transferring all interests in property other than the qualifying income interest….Therefore, the donee spouse is treated as making a gift under Section 2519 of the entire trust less the qualifying income interest, and is treated for purposes of Section 2036 as having transferred the entire trust corpus, including that portion of the trust corpus from which the retained income interest is payable.”[9]

Under Treasury Regs. Section 25.2519-1(f), the sale of qualified terminable interest property, followed by the payment to the donee spouse of a portion of the proceeds equal to the value of the donee spouse’s income interest, is considered a disposition of the qualifying income interest.[10]

This rule suggests that any transfer of QTIP trust assets to a person other than the surviving spouse during the surviving spouse’s lifetime can cause the surviving spouse to have made a deemed gift equal in value to the total value of the assets in the QTIP trust. It is suggested that the reasoning behind this rule is to ensure that the proceeds from a disposition of the income interest that an income beneficiary receives will continue to be fully taxable.[11]

IV. The Tax Court’s Opinion in Estate of Anenberg

In the Estate of Anenberg v. Commissioner[12], QTIP trusts were established by Alvin Anenberg for his wife, Sally. Three years after Alvin’s death in 2008 and with the consent of remainder beneficiaries, the QTIP trusts were terminated by a court, and assets were distributed to Sally. A few months later, Sally gifted a part of the assets to trusts for Alvin’s children and then sold the remaining interests to trusts for Alvin’s descendants in exchange for promissory notes. Sally filed gift tax returns for the gifts to trusts for Alvin’s children. Sally subsequently died and the IRS made gift tax claims of $9M against her estate. The IRS had two arguments: (i) that the termination of the QTIP trust was a disposition of Sally’s qualifying income interest under Section 2519, or (ii) that the termination of the QTIP trust and later sale was a deemed transfer under Section 2519.[13]

The Tax Court analyzed whether the termination and sale were considered a gift subject to gift tax. The Court referenced prior US Supreme Court opinions that defined a gift as “proceeding from detached and disinterested generosity.”  The Court also discussed the “QTIP regime” as being a legal fiction “under which the surviving spouse is treated as receiving all of the QTIP, when in reality the surviving spouse acquired only a lifetime income interest in that property.”[14]

Addressing the arguments, the Tax Court found that no gift occurred at the termination of the QTIP trust when the assets were distributed to Sally, because even if a transfer occurred under Section 2519, she ended up owning all of the assets and there was no gratuitous transfer, which is what Section 2501 requires.  The Court cited other cases in which the surviving spouse did not receive anything for the termination and a gift tax was assessed. The court stated that “At the end of the day, she gave away nothing of value as a result of the deemed transfer. Accordingly, the termination of the Marital Trusts did not result in any ‘gratuitous transfers’ by Sally, deemed or otherwise.”[15]

Second, the Tax Court found that there was no deemed transfer under Section 2519 because following the termination of the QTIP trust, the qualifying income interest terminated, and Sally could not have disposed of something that no longer existed.[16]

The Tax Court did not state an opinion on whether the other beneficiaries could be treated as making a gift to Sally for gift tax purposes.

The Tax Court’s opinion in the Anenberg case contrasted the IRS’s position previously stated in Chief Counsel Memoranda 2021-18008, where it found that the termination of a QTIP Trust where assets were distributed to a surviving spouse would result in a gift by the spouse under Section 2519 and by the remainder beneficiaries under Section 2511, and that these gifts do not offset each other.[17]  The logic used here was that a commutation of the trust resulted in terminating distributions to the holders of the beneficial interests in the trust equal to the actuarial value of the interests.  This terminates the relationship between the beneficiary and the trust and constitutes a disposition of the spouse’s qualifying income interest under Section 2519(a). Therefore, the spouse was treated as transferring all interests in the trust other than the qualifying income interest.[18]  With respect to a gift made by the trust beneficiaries, the IRS found that when the trust terminated, the children’s remainder interest vested in them as remaindermen. The children then transferred this property interest to the spouse and received nothing in exchange. This memo characterized this transaction as a gift under Section 2512(b).[19]

V. The Tax Court’s Opinion in McDougall v. Commissioner

The case referred to in Chief Counsel Memorandum 2021-18008 above was later litigated in McDougall v. Commissioner.[20] In this case, the surviving spouse, Bruce, had an income interest in a QTIP trust established by the decedent. The decedent’s two children, Linda and Peter, were the remainder beneficiaries. Bruce, Linda, and Peter entered into a nonjudicial settlement agreement whereby the assets in the QTIP trust were commuted and distributed to Bruce. Bruce then sold some of those assets to other trusts for the benefit of Linda and Peter, in exchange for promissory notes. Gift tax returns were filed by Bruce and each of the children, reporting these transactions. The gift tax returns included statements that the commutation of the trust and distribution of all assets to Bruce resulted in a deemed gift of the trust assets to the children, and a deemed gift of the remainder interest from the children to Bruce. The family argued that no taxable gifts resulted from these transfers because the gifts offset each other.[21]

The IRS argued that the agreement to commute the trust was a disposition of Bruce’s qualifying income interest pursuant to IRC 2519 and resulted in gift tax liability. Alternatively, the IRS argued that the commutation together with the transfer in exchange for promissory notes was a disposition of Bruce’s qualifying income interest under IRC 2519 and resulted in gift tax liability. Finally, the IRS argued that the agreement to commute the marital trust resulted in gifts by the children to Bruce.

The Tax Court followed its logic used in the Estate of Anenberg v. Commissioner. As discussed above, the Tax Court observed that IRC 2519 requires a gratuitous transfer. In this case, the Tax Court held that Bruce was not liable for gift tax under IRC 2501 because there was no gratuitous transfer. The Tax Court did not agree with the IRS’s alternative argument and held that the transfer of the marital trust property in exchange for the promissory notes did not result in gifts from Bruce to the children. The Tax Court did however agree with the IRS’s argument that the agreement to commute the marital trust resulted in gifts by the children to Bruce under IRC 2511. The Tax Court found that Linda and Peter made gratuitous transfers because they did not receive anything in return for their agreement that the QTIP assets transfer to Bruce. Therefore, they were subject to gift tax under Sections 2501 and 2511. This finding aligns with the IRS’s conclusion in Chief Counsel Memorandum 2023-52018, where it found that the modification of an irrevocable grantor trust to add a tax reimbursement clause was a taxable gift by the beneficiaries of part of their interests in the trust because they relinquished certain rights in favor of the grantor.[22]

The Tax Court rejected the argument that the gifts offset because it said that “Section 2519(a) does not deem a gift; it merely deems a transfer.”[23]  It concluded that “there are no deemed gifts from Bruce to the children to offset the gift from the children to Bruce.”[24]  The Tax Court further argued that the children did not obtain anything of value from Bruce to offset the value they gave up by relinquishing their remainder rights.[25]

VI. Practical Implications

The Tax Court’s decisions in Estate of Anenberg v. Commissioner and McDougall v. Commissioner provide clarification regarding the tax consequences associated with the termination or commutation of QTIP trusts. These rulings suggest that, under certain circumstances, a surviving spouse who receives full ownership of QTIP trust assets upon termination may not be subject to gift tax under Sections 2501 or 2519. However, estate planners must proceed with caution, as the remainder beneficiaries may be deemed to have made taxable gifts under Section 2511 if they relinquish their remainder interests without receiving adequate consideration. Therefore, estate planners should ensure that any proposed modification or termination of a QTIP trust is evaluated not only for its income and estate tax implications but also for potential gift tax exposure among all beneficiaries. Careful documentation, consideration of alternative strategies such as decanting trust assets to more favorable trusts or using powers of appointment strategically are imperative when navigating these complex transactions.

VII. Monitoring Future Developments

Given the IRS focus on cases dealing with Section 2519, estate planners must closely monitor future developments in this area. It remains uncertain whether the IRS will continue to challenge similar QTIP trust terminations under its broader interpretation of Section 2519 and Section 2511 or whether it will revise its guidance in light of recent Tax Court decisions. Furthermore, changes in tax legislation or new IRS regulations could reshape the tax treatment of QTIP trust modifications or terminations. Planners should remain alert for additional case law, IRS pronouncements, or possible legislative reforms that could clarify or alter the current legal landscape. Regular reviews of trust structures and ongoing education in this evolving area will be essential for practitioners to effectively advise clients and mitigate the risk of unforeseen tax consequences.

 

Kathi L. Ayers is a principal in the law firm of Vaughan, Fincher & Sotelo, PC, an organization dedicated to providing estate planning and estate administration services to individuals, families, and their businesses in the Washington Metropolitan area. Kathi received her J.D. from George Mason University School of Law in 2007, and her undergraduate degree in biochemistry from Eastern College in St. Davids, PA in 2001. She is a member of the Bars of Virginia, Maryland, and the District of Columbia. Kathi is a member of the inaugural class of the ACTEC Southeast Fellows Institute and is a member of the Legislative Committee of the Virginia Bar Association’s Wills, Trusts, and Estates section. Kathi previously served as a co-chair of the Wills, Trusts and Estates section of the Fairfax County Bar Association and is a member of the Northern Virginia Estate Planning Council. Kathi has been named as a Rising Star in DC and Virginia Superlawyers and as a “Top Financial Professional” and “Top Lawyer” in Washingtonian and Northern Virginia magazines.

---

[1] Estate of Anenberg v. Commissioner, 162 T.C. No. 9 (May 20, 2024).

[2] McDougall v. Commissioner, 163 T.C. No. 5 (September 17, 2024).

[3] I.R.C. §2056

[4] I.R.C. §2056(b)(7)(B)

[5] I.R.C. §2056(b)(7)(B)

[6] Treas. Reg. §20.2056(b)-5(f)(7)

[7] I.R.C. §2044 and I.R.C. §2519

[8] Kirkland, Robert K. (2024, May). Not Too Rich, Not Too Poor: Transferring Wealth for the Middle Rich by Robert K. Kirkland. Presented at Rady Children’s Professionals Symposium. Retrieved from https://radyfoundation.org/wp-content/uploads/2024/05/Transferring-Wealth-for-the-Middle-Rich_Bob-Kirkland_051324.pdf.

[9] Treas. Reg. § 25.2519-1(a)

[10] Treas. Reg. § 25.2519-1(f)

[11] https://www.mitchellwilliamslaw.com/think-twice-before-you-end-a-trust-income-tax-consequences-of-trust-commutations-and-early-terminations#_ftn9

[12] Estate of Anenberg v. Commissioner, 162 T.C. No. 9 (May 20, 2024).

[13] Id.at 19.

[14] Id.at 4.

[15] Id.at 15.

[16] Id.at 18-19.

[17] CCA 202118008 (2021).

[18] Id.

[19] Id.

[20] McDougall v. Commissioner, 163 T.C. No. 5 (September 17, 2024).

[21] Id.at 6.

[22] CCA 2023-52018 (2023).

[23] McDougall at 14.

[24] Id.

[25] Id.