Pay Early, Pay Less: Maximizing TPT Credit Availability for Married Couples
Section 2013 of the Internal Revenue Code1 allows a federal estate tax (FET) credit in situations in which the decedent (referred to herein as the “transferee”) received, either 10 years before or two years after death, property in a transfer (from the “transferor”) that was also subject to FET (TPT credit). While the intended purpose of the TPT credit is to avoid excessive taxation when successive deaths occur in a short period of time, well-drafted estate plans allow application of the TPT credit to result in FET savings for married couples when the transferee spouse dies within 10 years of the transferor spouse.2 On its face, especially with a non-graduated flat estate tax rate of 40 percent, paying taxes on the first death appears to be a wash because the total property subject to tax in both estates will be the same. The “magic” occurs because, under a strict application of §2013, some of the surviving spouse’s interests in the resulting trusts created under the first to die’s estate plan — which are not includible in his or her gross estate3 — actually generate the TPT credit. Therefore, a credit is given for property that, in actuality, does not add to the surviving spouse’s gross estate, which has the effect of lowering the combined estate taxes paid by the spouses.
TPT Credit Mechanics
The starting point when calculating the TPT credit is determining whether the transferor has “transferred” to the transferee any “property” included in the transferor’s gross estate (transferred property). Treas. Reg. §20.2013-5(b) provides an open-ended definition of “transfers,” which includes, but is not limited to, receipts of property: 1) under dower or curtesy; 2) as surviving joint tenant via survivorship rights; 3) as a life insurance beneficiary; 4) as a survivor under an annuity contract; 5) as a donee/possessor of a general power of appointment (GPOA); 6) as appointee under an exercised GPOA; or 7) as a remainder beneficiary under a release or lapse of a power of appointment by reason of which the property is included in the gross estate of the donee of the power under §2041. Treas. Reg. §20.2013-5(a) defines property as “any beneficial interest in property, including a [GPOA]….”4 These broad regulatory definitions of “transfer” and “property,” which do not require the transferred property to be included in the transferee spouse’s gross estate or even exist when the transferee spouse dies, are what allow significant FET savings to be generated in the transferee spouse’s estate.
The TPT credit is restricted in two significant ways. First, the TPT credit is limited to the lesser of 1) the amount of FET attributable to the transferred property in the transferor spouse’s estate (the first limitation)5; and 2) the amount of FET attributable to the transferred property in the transferee spouse’s estate (the second limitation) (the lesser of the first limitation and second limitation are referred to collectively hereafter as the “FET liability limitation”).6 The first limitation is calculated by multiplying the transferor’s net FET liability7 by the value of the transferred property,8 and then dividing that result by the transferor’s net taxable estate.9
Unlike the first limitation, the second limitation is a theoretical calculation that, as alluded to in this article’s introduction, does not require the transferred property to be traced into the transferee spouse’s gross estate. Put simply, the second limitation is determined by subtracting the net FET liability on the transferee’s estate, including the transferred property (the greater transferee FET liability) from the net FET liability on the transferee’s estate, excluding the transferred property (the lesser transferee FET liability). In practice, this calculation is less than straightforward and contains multiple traps for the unwary.
The easiest part of the second limitation is determining the greater transferee FET liability, which is identical to a normal estate tax calculation except with the inclusion of the transferred property in the gross estate. When calculating the lesser transferee FET liability, “wrinkles” appear when the transferee’s estate is entitled to charitable and, possibly, in the event of a remarriage, marital deductions. Treas. Reg. §20.2013-2(b) presumes that any charitable deduction in the transferee’s estate is satisfied proportionally out of all estate assets, including the transferred property. There is no regulatory corollary for an augmented marital deduction in the transferee’s estate (which can only occur if the transferee remarries); while no authority exists on this point, the same logic would seem to apply.
Section 2013(a) provides that if the transferee spouse dies within two years of the transferor spouse’s death, the TPT credit is allowed at 100 percent of the FET liability limitation. If the transferee spouse dies more than two but within 10 years of the transferor spouse’s death, the TPT credit is reduced incrementally based on when, in the above timeframe, the transferee spouse dies (the time limitation). If the first death occurs more than two, but within four years before the second death, the amount allowed by the FET liability limitation is reduced to 80 percent; if the second death occurs more than four, but within six years before the first death, the time limitation becomes 60 percent; if the second death occurs more than six, but within eight years before the first death, the time limitation becomes 40 percent; and if the second death occurs more than eight, but within 10 years before the first death, the time limitation becomes 20 percent. If the transferee spouse survives the transferor spouse by more than 10 years, the TPT credit is entirely disallowed by virtue of the time limitation.
The typical estate plan for married couples who wish to benefit each other consists of the creation of a bypass or “credit shelter” trust (CST) that utilizes the transferor spouse’s applicable exclusion amount under §2010 (AEA), with the balance of assets passing into one or two mandatory income trusts for the surviving spouse that is/are entitled to qualify for the federal estate tax marital deduction under §2056(b)(7) as “qualified terminal interest property” (QTIP).10 Under these plans, the FET liability limitation practically requires the decision to utilize the TPT credit (or not) to be made prior to the due date for payment of the transferor spouse’s FET liability (usually, nine months unless an extension for time to pay estate taxes is successfully filed), because the amount of FET attributable to the transferor spouse for transferred property held in the marital trust(s) (i.e., the numerator of the first limitation) will be zero (or near zero)11 if full QTIP elections are made.12 If the transferee spouse dies or is on “death’s door” before the transferor spouse’s FET becomes due, this decision can be made with confidence. If, however, the surviving spouse’s only identifiable mortality risk factor is age, not making the QTIP election becomes a gamble on the transferee spouse’s life by the transferor spouse’s personal representative (and their estate administration counsel).
Maximizing Potential Federal Estate Tax Savings Via the TPT Credit
As noted above, the TPT credit will probably only be more advantageous than a full QTIP election marital deduction when the transferred property is included in the TPT credit calculation but not in the gross estate of the transferee spouse. For TPT credit purposes, such property (TPT advantaged property) will include the transferee spouse’s income interests in trust (assuming such interests are capable of valuation), certain general powers of appointment the transferee spouse has over trust principal, and potentially a lifetime right to trust principal under an ascertainable standard (i.e., for health, education, maintenance, or support).
Spousal Life Tenancy Interests
The surviving spouse’s interest in the marital trust(s) will, at a minimum, consist of a lifetime right to all trust income that qualifies as transferred property for TPT credit purposes.13 Additionally, many married clients’ plans dictate the bequest of some property outright to the surviving spouse, for which an additional TPT credit qualifying life interest can be generated if the surviving spouse executed a qualified disclaimer14 of such property that results in the transfer of said property to either the CST15 or a separate trust in which the transferee spouse has a mandatory income interest for life.
Under Treas. Reg. §20.2013-4, valuation of these life interests for TPT credit purposes is determined as of the date of the transferor spouse’s death on the basis of recognized valuation principles. Pursuant to Treas. Reg. §§20.2031-7 and 20.7520-1 through 20.7520-4, such a life estate is determined by multiplying the fair market value of the marital trust(s) assets subject to the life estate(s)16 by an actuarial factor set forth in Table S of IRS Publication 1457 as determined by the “Section 7520 rate” (i.e., 120 percent of the federal midterm rate in effect under §1274(d)(1) at the transferor’s death) and the age of the transferee spouse on the date of the transferor spouse’s death. Because a life estate without either a retained interest or a GPOA over the balance is not included in the life tenant’s gross estate for FET purposes, a TPT credit for the value of the transferee spouse’s life estate in the marital trust(s) is not offset by any additional FET liability, resulting in cumulative FET savings for the couple. The younger the transferee spouse at death, the greater the value of the marital trust(s) life estate(s), and consequently the greater FET savings will be generated by not obtaining a marital deduction for such marital trust(s).
The above valuation method of the transferee spouse’s life estate in trust income is subject to three exceptions: common accidents (i.e., simultaneous deaths), terminal illnesses, and in circumstances in which production of income is too uncertain. Treas. Reg. §20.7520-3(b)(3)(iii) states that the mortality tables cannot be used to determine the income interest of a life tenant who dies in a common accident with the transferor of such interest. Thus, if the transferor spouse and the transferee spouse die simultaneously, the value of the resulting marital trust(s) life estate(s) will be zero.17
Regarding a “terminal illness,” at the transferor spouse’s death, the transferee spouse is known to be “terminally ill,”18 Treas. Reg. §§20.7520-3(b)(3)(i) and 20.7520-3(b)(3)(ii) preclude the use of mortality tables in valuing the life estate(s) contained in the marital trust(s), subject to one exception. For TPT credit purposes only, the mortality tables may be used if the life estate was required to be valued in the transferor spouse’s gross estate and if a final determination of estate tax liability has been made with respect to the transferor spouse’s estate. Usually, the transferee spouse’s life tenancy in the marital trust(s) will fail to qualify for this exception, as the life estate is not required to be valued for purposes of calculating the transferor spouse’s FET liability.19
On one hand, the TPT credit has been denied by courts and the IRS for spousal lifetime income interests in trusts in which it cannot be reasonably guaranteed that trust income will be distributed to the transferee spouse.20 On the other hand, the TPT credit has been allowed in numerous situations when the lifetime income for the transferee spouse is less certain than under a marital trust.21
Although not binding legal authority, the Service’s Chief Counsel Advisory 200218003 indicates that the IRS will potentially allow a TPT credit for spousal lifetime interests in trust corpus subject to trustee discretion but limited by an ascertainable standard.22 In this situation, the trustee was authorized to invade a marital trust (for which only a partial QTIP election was made) in order to pay to, or for the benefit of, the transferee spouse any amounts deemed “necessary or desirable, consistent with [transferee spouse’s] accustomed standard of living, for her health, maintenance, or support.” The Office of Associate Chief Counsel determined that this interest qualified for the TPT credit to the extent attributable to the portion of the marital trust for which the QTIP election was not made. However, the burden fell on the estate to prove the value of the interest, which depended on various factors, including 1) the transferee spouse’s annual requirements for health, maintenance, and support; 2) the likelihood trust principal would be invaded; and 3) the extent to which the trustee took the transferee’s income interest and other resources into account in determining the extent of the invasion power. As with a life tenancy in trust income, a spousal lifetime discretionary “HEMS” right to principal will be TPT advantaged property because the interest will qualify for the TPT credit but, by virtue of extinguishing on the transferee spouse’s death, will not be included in the transferee spouse’s gross estate for FET purposes.
Spousal Withdrawal Rights
As noted above, Treas. Reg. §20.2013-5(b) specifically identifies GPOAs granted to the transferee spouse as a “beneficial property interest” for TPT credit purposes. Because §2041 includes in the transferee spouse’s gross estate any GPOAs held by said spouse at death, a GPOA granted to the transferee spouse will only be TPT advantaged property if it does not exist on the transferee spouse’s death. Thus, a GPOA granted by the transferor spouse to the transferee spouse must necessarily be extinguished during the remainder of the transferee spouse’s life to create any net FET benefit via the TPT credit.23
Under §2514, the exercise or release of a GPOA will be treated as a transfer by the transferee spouse subject to gift tax. However, §2514(e) provides that the lapse of a GPOA (i.e., the failure of the transferee spouse to exercise a time-limited GPOA) only constitutes a gift-taxable release to the extent the amount able to be appointed in a calendar year exceeds the greater of $5,000 or 5 percent of the aggregate value of the assets subject to the GPOA. Thus, granting the transferee spouse so called “5-or-5” powers in the CST and marital trust(s) (i.e., a right to withdraw no more than the greater of $5,000 or 5 percent of trust principal) can potentially generate a significant TPT credit without attendant FET or gift tax liability, even if the power lapses shortly after the transferor spouse’s death.
The IRS has confirmed that GPOAs, and specifically 5-or-5 powers, that lapse prior to the transferee spouse’s death will qualify as transferred property. In Revenue Ruling 66-38, the IRS concluded that the transferee spouse’s GPOA qualified for the TPT credit, despite being only exercisable for one year following the transferor spouse’s death.24 In Revenue Ruling 79-211 and several Private Letter Rulings (PLRs)25 the value of noncumulative 5-or-5 powers were included in the calculation of the TPT credit available to the transferee spouse. Notably, in PLR 8830055, the IRS clarified that when the transferee spouse is given a 5-or-5 power in a trust in which said spouse also has a lifetime right to all trust income, the value of the income right is based only on trust principal not subject to the transferee spouse’s GPOA (i.e., the actuarial factor provided in Table S will be multiplied by the lesser of 95 percent of trust principal or entire trust principal less $5,000).
The critical factor for the IRS in determining whether the value of a GPOA qualifies for the TPT credit seems to be whether the power exists and is capable of valuation on the date of the transferor spouse’s death.26 Thus, in the year of the transferor spouse’s death, the transferee spouse’s 5-or-5 power should be exercisable immediately and not be tied to a specific day of the year. Drafters including a spousal GPOA solely to generate a TPT credit might go one step further and grant a 5-or-5 power only in the year of the transferor spouse’s death that is exercisable only for a short period (for example, 24 hours)27 following the transferor spouse’s death. Under this approach, assuming the transferee spouse survives by at least one day,28 the 5-or-5 power should qualify for the TPT credit, lapse free of gift tax, and be excluded from the transferee spouse’s gross estate, resulting in cumulative FET savings.
Money Isn’t Everything
Despite the significant FET tax savings from proactively generating the TPT credit in the above circumstances, nontax factors must be taken into consideration both in the pre-mortem and post-mortem planning phases. For instance, while a maximum TPT credit may be generated by providing the transferee spouse with all trust income annually for life in all resulting trusts for which the QTIP election is not made (i.e., the CST and non-QTIP electing portions of the marital trust(s)), more often than not clients would rather the trustees be allowed to “sprinkle” trust income among their surviving spouses and other beneficiaries. Because the TPT credit is contingent on the transferred property being capable of valuation, a pure sprinkle provision without any identifiable portion of income guaranteed for the transferee spouse will preclude a TPT credit for the spousal income life tenancy, not to mention that such terms would not allow QTIP treatment.
Creditor protection may be another nontax reason to forego drafting a married couples’ estate plan to maximize the TPT credit. This concern may arise specifically when considering whether to give 5-or-5 powers or guaranteed trust income to a transferee spouse with known or potential creditors. Even if withdrawal powers are drafted to expire within 24 hours of the transferor spouse’s death, the mere fact that the transferee spouse could have exercised the power in favor of himself or herself could be enough to sustain a successful creditor claim.
Coupled with the risk that the transferee spouse could survive the transferor spouse by more than 10 years, drafting decisions that benefit the TPT credit over other nontax benefits may be a “hard sell” to many clients. And, even when the TPT credit is drafted for optimal implementation in accordance with the client’s wishes, the personal representative of the transferor spouse’s estate must still be convinced to cut what is usually a substantial check to the IRS earlier than need be. While the potential economic advantage of the TPT credit is well established, for some, the psychological hurdle of “premature tax payments” is insurmountable. For these reasons, drafting counsel may wish to integrate a backup disclaimer trust with greater trustee discretion over trust income and principal (i.e., sprinkle provisions and restricted or nonexistent principal withdrawal rights), although such planning requires the transferee spouse to make a qualified disclaimer within nine months of the transferor spouse’s death.
Even when client preferences prevent drafting for a maximum TPT credit, classic marital planning with marital trust(s) necessarily allows for some amount of credit due to the option not to make the QTIP election. As such, when married couples die prior to the FET return due date of the first spouse to die, or when the surviving spouse is expected to die sooner rather than later and is not “terminally ill” at the time of the first to die spouse’s death, counsel for the personal representative should, as soon as practicable, run the numbers to see whether it pays to pay early.
1 For purposes of this article, section references shall be to sections of the Internal Revenue Code of 1986, as amended.
2 While this article focuses on TPT credit planning considerations, it should be noted that the TPT credit is available in any situation in which property passes between two individuals with FET liability who die within 10 years of each other.
3 For all purposes of this article, the term “gross estate” shall refer to the “gross estate for federal estate tax purposes under I.R.C. §2013.”
4 Limited powers of appointment (LPOAs) do not qualify.
5 I.R.C. §2013(b) defines the first limitation as “an amount which bears the same ratio to the estate tax paid…with respect to the estate of the transferor as the value of the property transferred bears to the taxable estate of the transferor (determined for purposes of the estate tax) decreased by any death taxes paid with respect to such estate.”
6 Note, however, that the first limitation uses the average rate of estate tax for the transferor spouse’s estate, while the second limitation uses a marginal rate approach for the transferee spouse’s estate.
7 The transferor’s net FET liability is the transferor’s gross estate, less all available deductions and remaining applicable exclusion amount, multiplied by the transferor’s average FET rate and further reduced by any credits for pre-1977 gift taxes paid and previously taxed property.
8 The value of the transferred property is the full value of the transferred property, less any marital deduction attributable to the transferred property.
9 The transferor’s net taxable estate is the transferor’s gross estate, less all available deductions and all federal, state, and death taxes paid.
10 Very often, two QTIP trusts are established to maximize the decedent’s generation-skipping transfer (GST) tax exemption; generally speaking, a “reverse-QTIP” election is made under I.R.C. §2652(a)(3) so that the decedent continues to be treated as the transferor for GST tax purposes.
11 If a full QTIP election is made, the FET attributable to transferred property will be near zero only if some transferred property passes to the transferee spouse outside of the marital trust(s) in a manner that does not garner a marital deduction.
12 If a partial QTIP election is made, the FET liability limitation would not be zero because some (rather than no) FET would be paid in the transferor spouse’s estate for the assets passing via the marital trust(s). While a partial QTIP election could be made if there is limited appetite for paying FET on the first death, practically speaking, the desire to optimize FET liability collectively amongst the married couple should make the QTIP election decision “binary.”
13 I.R.C. §2056(b)(7)(B)(ii)(I).
14 I.R.C. §2518.
15 In a classic estate plan that maximally funds the CST with the balance of the first dying spouse’s AEA, directing such disclaimed assets (by the terms of the testamentary document, not the disclaimer) to the CST will, in turn, transfer additional assets to the marital trust(s) in which the disclaiming spouse has a mandatory life income interest that qualifies for the TPT credit. Additionally, the credit shelter trust may be drafted to provide a mandatory income interest to the surviving spouse for life, although it is often preferable to allow trust income to be sprinkled among the transferee spouse and the transferor spouse’s descendants in order to keep such income out of the surviving spouse’s estate.
16 As discussed further below, the value of the transferee spouse’s general powers of appointment over marital trust assets must be excluded from this calculation because such property could be immediately withdrawn and, thus, creates no marital trust income for the transferee spouse. Moreover, the inclusion of a testamentary GPOA raises the issue of whether the spousal trust could be considered an I.R.C. §2056(b)(5) power of appointment trust; such a construction would not permit a QTIP election (or lack of one in this case) to be made, which is the mechanism that causes estate tax upon the first death.
17 This principle, specifically in the context of the TPT credit, is further supported by a long line of case law predating and postdating the enactment of I.R.C. §7520. See Estate of Harrison v. Comm’r, 115 T.C. 161, 167 (2000); Estate of Carter v. U.S., 921 F.2d 63 (5th Cir. 1991); Estate of Lion v. Comm’r, 438 F.2d 56 (4th Cir. 1971), aff’g. 52 T.C. 601, 1969 WL 1618 (1969); Estate of Marks v. Comm’r, 94 T.C. 720, 1990 WL 67339 (1990); Old Kent Bank & Trust Co. v. U.S., 292 F. Supp. 48 (W.D. Mich. 1968), rev’d. on other grounds, 430 F.2d 392 (6th Cir. 1970).
18 Treas. Reg. §1.7520-3(b)(3) defines a terminal illness as an incurable illness or other deteriorating physical condition and there is at least a 50 percent probability that the individual will die within one year. However, if the transferee spouse survives the transferor spouse for 18 months or longer, the transferee spouse is presumed not terminally ill unless the contrary is established by clear and convincing evidence.
19 Situations in which a life estate is required to be valued in the transferor’s gross estate include 1) where the transferor spouse transferred gross estate property in trust for a third-party life tenant, remainder to transferee spouse; and 2) where a life estate included in the transferor spouse’s gross estate is on the life of a third party.
20 In Holbrook v. U.S., 575 F.2d 1288 (9th Cir. 1978), the Ninth Circuit denied a TPT credit for such an interest when the trustees were authorized to invest in unproductive property. In Rev. Rul. 67-53, 1967-1 CB 265, the IRS disallowed a TPT credit when trustees had absolute and unlimited discretion to distribute income to the transferee spouse or accumulate it for remainder beneficiaries. In Estate of Pollack v. Comm’r, 77 T.C. 1296 (1981), the Tax Court denied the TPT credit where the trustees had discretion to sprinkle income amongst the transferee spouse and the transferor spouse’s children, regardless of the fact that the trustees actually exercised their discretion in favor of the transferee spouse. In Private Letter Ruling (PLR) 8717006, the spousal lifetime income interest was held incapable of valuation where the trustee was permitted to distribute income to the transferee spouse to continue an accustomed standard of living, taking into account other sources of income, with the discretion to distribute excess income to the transferee spouse’s children. Finally, in Am. Nat. Bank & Trust Co. of Chattanooga, Tenn. v. U.S., No. 6373, 1972 WL 480 at *1 (E.D. Tenn. Nov. 14, 1972), the Eastern District Court of Tennessee denied the TPT credit when the transferee spouse’s lifetime income interest was contingent on both her other sources of income falling below a fixed amount and trust income being adequate to fulfill other trust obligations.
21 In Boryan v. U.S., 690 F. Supp. 459 (E.D. Va. 1988), aff’d on other issue, 884 F.2d 767 (4th Cir. 1989), the Eastern District Court of Virginia allowed a TPT credit for the transferee spouse’s income interest where the trust instrument stated that the trustee “shall” pay income to the transferee spouse but thereafter directed income not disbursed to be added to principal (the court construed the accumulation language as applying only after the transferee spouse’s death). The Boryan Court also held that a trustee authorization to invest in assets “as it may deem best without being required to confine itself to such investments as are usual or as are approved or authorized by law for investment by fiduciaries” did not constitute an unusual or uncontrolled discretion that would preclude a TPT credit under the Holbrook rationale discussed above. Id. In Estate of Lloyd v. U.S., 650 F.2d 1196 (Ct. Cl. 1981), and Estate of Weinstein v. U.S., 820 F.2d 201, 205 (6th Cir. 1987), the Court of Claims and Sixth Circuit, respectively, allowed TPT credits for transferee spouse’s income interest in sprinkle trusts (attacked by the IRS for being insusceptible to valuation) because state law and a testatorial intent to primarily maintain the transferee spouse were found to impliedly immunize a portion of trust corpus from invasion; in these cases, the transferee spouse’s actuarial factor was multiplied by the value of the corpus not subject to invasion. In Rev. Rul. 85-111, 1985-2 C.B. 196, a spousal lifetime income interest did not fail to qualify for the TPT credit by virtue of terminating on remarriage; instead, the contingency was required to discount the value of the life tenancy.
22 IRS CCA 200218003 (May 3, 2002).
23 As stated above in endnote 16, it is critical that the surviving spouse does not have such a power at death so that the IRS cannot make the argument that the spousal trust is an I.R.C. §2056(b)(5) trust, rather than an I.R.C. §2056(b)(7) QTIP trust.
24 Rev. Rul. 66-38, 1966-1 C.B. 212.
25 See PLR8830055, 8209054, 8029082, and 7837070.
26 The IRS specifically made this point in Rev. Rul. 66-38.
27 While there is no authority on the length of time the spousal GPOA must exist to qualify for the TPT credit, the authors believe that a withdrawal period of less than a day is unnecessarily aggressive.
28 As discussed above, in a simultaneous death, the TPT credit will be disallowed.
David Pratt is the chair of the personal planning department of Proskauer Rose LLP and the managing partner of the firm’s Boca Raton office. He is a fellow of the American College of Trust and Estate Counsel and American College of Tax Counsel, is Florida board certified in taxation and wills, trusts and estates, and has served on The Florida Bar’s Real Property, Probate and Trust Law Section’s Wills, Trusts and Estates Certification Committee. He is also a past chair of The Florida Bar’s Tax Section and an adjunct professor at the University of Florida Levin College of Law and the University of Miami Law School.
Michael Rosenblum is an associate in the personal planning department of Proskauer Rose LLP’s Boca Raton office. He received his B.A. in English from the George Washington University, his J.D. from Emory University School of Law, and his LL.M. in estate planning from the University Miami School of Law. He is licensed to practice law in New York, Florida, and Colorado.
This column is submitted on behalf of the Tax Law Section, William Roy Lane, Jr., chair, and Christine Concepcion, Michael Miller, and Benjamin Jablow, editors.