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We previously posted on the gift tax implications of terminating a Qualified Terminable Interest Property Trust (“QTIP”) before the death of the surviving spouse (“spouse”). To recap, a termination of a QTIP trust whereby the spouse relinquishes his or her entire interest in the trust gives rise to taxable gifts by the spouse under Code sections 2511 (i.e., the gift of the income interest) and 2519 (i.e., the gift of the remainder interest). When a Code section 2519 gift occurs (as opposed to a Code section 2511 gift for which there is no right of recovery), Code section 2207A gives the spouse a right to recover the gift taxes from the trust. Our prior post did not, however, discuss the impact of Code section 2035(b) when the spouse dies within three years of the trust termination. Code section 2035(b) adds to the gross estate for federal estate purposes the amount of any gift taxes paid on gifts made by the decedent within three years of death (“2035 gross up”). Does the 2035 gross up apply when the spouse makes a Code section 2519 gift but the taxes are recovered by the spouse from the QTIP trust?
This was the subject of Estate of Anne Morgens v. Commissioner, No. 10-73698, 9th Cir. (May 3, 2012), Aff’g 133 T.C. No. 17 (December 21, 2009) (“Morgens case”). In the Morgens case, the U.S Court of Appeals for the Ninth Circuit affirmed the Tax Court’s holding that gift tax paid on a Code section 2519 gift is includible in the spouse’s estate under Code section 2035(b) when the spouse dies within three years of the trust termination notwithstanding the spouse’s exercise of the right of recovery from the trust under Code section 2207A. In the Morgens case, the spouse relinquished her entire interest in two QTIP trusts. Gift tax was imposed for each trust under Code sections 2511 and 2519, and the spouse exercised her right under Code section 2207A to recover the gift tax from the trusts resulting from the Code section 2519 gifts. The issue in the Morgens case was whether Code section 2035(b) applies to the taxes resulting from the Code section 2519 gifts since such taxes were actually borne by the trusts rather than the spouse as a result of her exercise of the right of recovery under Code section 2207A. The Court held that Code section 2035(b) applies based upon its finding that the spouse was legally responsible for the tax notwithstanding her right to recover the taxes from the trusts.
As a result of the Morgens case, the surviving spouse’s estate tax may be increased because of the 2035 gross up, and such increase will be borne by the beneficiaries of the spouse’s estate which often are not the same beneficiaries of the first spouse to die. If an agreement is made to terminate a QTIP trust and a Code section 2519 tax results, the spouse may want to require that the remainder beneficiaries of the QTIP trust indemnify the spouse’s estate for any increased estate taxes that may result from the 2035 gross up should the spouse die within three years of the termination. If the spouse is insurable, the remainder beneficiaries of the QTIP trust might consider the purchase of short term life insurance on the spouse to pay for this potential increase in estate tax.