856 / When will a terminable interest in property cause that property to fail to qualify for the estate tax marital deduction?

Generally speaking, a terminable interest is deductible if no interest in the property passes to someone other than the surviving spouse or her estate which may be possessed or enjoyed after the spouse’s interest ends. Therefore, if the decedent transfers all interest in a straight life annuity, for instance, the interest will ordinarily qualify. There are two exceptions to this rule. Even though no one else takes an interest in the same property, a terminable interest will not qualify if (1) the decedent has directed the executor or trustee to acquire a terminable interest for the surviving spouse; or (2) an interest passing to the surviving spouse may be satisfied out of a group of assets which includes a nondeductible interest.¹

Where spouses own property as joint tenants with right of survivorship or as tenants by the entirety, upon the death of one spouse, the surviving spouse succeeds to absolute ownership of the entire property. This succession occurs by virtue of the form of ownership, not by virtue of any will provision or intestate succession laws. Such succession qualifies for the marital deduction, but only, of course, to the extent the interest to which the surviving spouse succeeds was includable in the decedent’s gross estate. (See Q 824.)

A terminable interest passing to a decedent’s spouse may be a deductible interest even though an interest in the property may be enjoyed by someone else after the interest ends if the interest is as follows: (1) terminable only because of a survivorship clause; (2) the right to income for life with general power of appointment over the property producing the income; (3) consists of life insurance or annuity proceeds held by the insurer under an agreement that gives the spouse a life income interest in the proceeds plus a general power of appointment over the proceeds; (4) a “qualifying income interest for life” in “qualified terminable interest property” (see Q 854).

A survivorship clause will preserve the marital deduction if (1) the only condition under which the surviving spouse’s interest will terminate is the death of the surviving spouse within six months after the decedent’s death, or death as a result of a common disaster, and (2) the condition does not occur.²

The IRS permits a QTIP trust to be reformed to meet the requirements of the estate tax marital deduction.³

An income interest does not fail to qualify as a qualifying income interest for life merely because the income accumulated by the trust between the last date of distribution and the surviving spouse’s death is not required to be either distributed to such spouse’s estate or subject to a general power of appointment exercisable by such spouse.⁴ However, any income from the property from the date the QTIP interest is created to the death of the spouse with the QTIP interest which has not been distributed before such spouse’s death is included in such spouse’s estate under IRC Section 2044 to the extent it is not included in the estate under any other IRC provision.⁵

In Technical Advice Memorandum (TAM) 9139001, the marital deduction was denied because (1) a son’s right to purchase stock in a QTIP trust at book value was treated as the power to withdraw property from the trust (i.e., as a power to appoint property to someone other than the spouse), and (2) the spouse and the trustee lacked the right to make the closely held stock, in which the son held all voting rights, income productive. Similarly, a marital deduction was denied where the trustee could sell stock in a QTIP trust to a son at book value.⁶ While TAM 9113009 had provided that a QTIP marital deduction would be denied if the non-QTIP portion of the estate were not funded with an amount equal to the face value of loans guaranteed by the decedent, it was withdrawn by TAM 9409018, which provided instead that the marital deduction would not be reduced by the entire unpaid balance of the guaranteed loans unless (1) at the time of death it would appear that a default after the marital deduction were funded would be likely, (2) that marital deduction property would be used to pay the entire unpaid balance of such loans, and (3) that subrogation rights held by the marital portion would appear to be worthless. According to TAM 9206001, a QTIP marital deduction was not available where the spouse was given an income interest in only certain types of property held in a trust and the trustee could change the mix of assets in the trust.

The IRS has conceded the validity of the contingent QTIP marital deduction (i.e., where the surviving spouse’s qualifying income interest is contingent upon the QTIP election being made), if the QTIP election is made.⁷

The term “property” includes an interest in property, and a specific portion of property is treated as separate property.⁸ However, a specific portion must be determined on a fractional or percentage basis.⁹ The term “property” also contemplates income-producing property. The deduction will thus be disallowed as to nonincome-producing property if under local law the spouse has no power to convert the property to income-producing property or to compel such conversion.¹⁰

A survivor annuity in which only the surviving spouse has a right to receive payments during such spouse’s life is treated as a qualifying income interest for life unless otherwise elected on the decedent spouse’s estate tax return.¹¹