Editor’s note: Steve Parrish is a columnist for Rethinking65 Read more of his articles here.
The federal estate tax doesn’t apply to many people, but when it does apply — it can sting. A recent case, Estate of Griffin v. Commissioner is a painful reminder of the importance of paying attention to details when using estate planning strategies. This wasn’t a case of tax abuse or aggressive planning gone bad. This case, filed May 19, involves a fairly vanilla estate-planning technique where an innocent failure to follow the rules led to outsized consequences.
Plaintiff Martin Griffin was wealthy. He had two children from a previous marriage and five grandchildren. When Martin married Maria Creel in 2018, he also became a stepfather to her three children. With this change in his family situation, he wanted to adjust his estate plan.
Back in 2012, Martin created a revocable trust. Then in July 2018, to manage his new marital status, he executed an amendment to the revocable trust and created a new irrevocable trust. Upon death the revocable trust was instructed to make a $2 million bequest to the irrevocable trust. The basic terms were that this irrevocable trust was to pay Maria a monthly income while she was alive, and then upon her death pay the proceeds to Martin’s descendants.
Two Goals
This type of estate planning arrangement is common, even when estate taxes are not involved. Many families — especially blended ones — face the challenge of honoring the decedent’s wish to provide for his or her surviving spouse while also ensuring that, after the spouse’s death, the remaining assets go to the decedent’s own heirs. Often these heirs are children from a previous marriage.
While protecting assets is a key planning goal for second marriages, wealthy families facing estate taxes often have another goal: Utilizing the estate tax marital deduction. The basic rule is that, because of the unlimited marital deduction, whatever goes to the decedent’s spouse at death totally escapes estate tax to the decedent. That’s a 40% tax on assets that can be avoided in the first estate.
But there’s a catch.
To qualify for the marital deduction, the bequest can’t be “terminal.” For example, the decedent can’t leave the surviving spouse a life estate in an asset and direct the asset to go to other heirs — for example children of the first marriage — when the spouse dies. This does not qualify for the marital deduction because the bequest to the surviving spouse was terminal.
QTIP to the Rescue
Congress has long recognized the inherent conflict this presents, particularly for blended families. The decedent wants the surviving spouse cared for during his/her life, wants the remainder at the survivor’s death to go to the decedent’s heirs, but still wants to utilize the marital deduction. So, in 1982, a provision was added to the IRC to allow for a “qualified terminal interest property” trust (known as a QTIP).
The rules are comparatively straightforward. First, the trust must pay annual interest to the surviving spouse — no exceptions. Second, to avoid any kind of gameplaying by the decedent or trustee, the surviving spouse can force the trust to have assets that are capable of producing income. Finally, the decedent’s executor must affirmatively elect to have the trust treated as a QTIP. In other words, at death the executor must declare the decedent’s intent to qualify the trust assets for the marital deduction.
The QTIP has become a commonly utilized technique in estate planning. The rules are clear, and the process has been around for decades. For many families it is a win-win: income to the surviving spouse, assets to the decedent’s heirs thereafter, and use of the marital deduction to avoid estate taxes. What could go wrong?
Martin died at age 60, just one year after marrying Maria and creating the irrevocable trust. When his executor filed the Form 706 estate tax return, the form did not list any property from the estate as QTIP property; the executor didn’t make the affirmative election. In a notice of deficiency, the IRS determined the $2 million bequest was includable in the decedent’s estate, and then applied an accuracy-related penalty.
The estate challenged this finding in court with a somewhat strained argument that the executor intended to list property from the estate as QTIP property, even though the executor failed to comply. The U.S. Tax Court agreed with the IRS, granting the government summary judgment (finding for the government without a full trial). The court didn’t mince words: “The $2 million bequest is not QTIP because the estate failed to make a valid QTIP election for that property and it is fully includible in the estate …”
How much did this error cost the Griffin family? A lost $2 million dollar deduction essentially means estate taxation of the trust assets at 40%, so the tax bill would be at least an additional $800,000. With interest and penalties, the actual cost would approach $1 million.
Important Reminders
This is not a case where a client was overly aggressive or attempted a previously untested estate strategy. A QTIP is a standard best practice in estate planning for blended families, and it’s a matter of black-letter law (well defined, undisputed and well known). It simply requires compliance with the rules.
It would be interesting to know how the new wife, the children from the first marriage, and the other parties responded after the IRS delivered the bad news to the estate. Did the executor call the attorney who handled the administration and taxes? Was the attorney’s next call to his or her errors-and-omissions carrier? And how will the loss of a large part of their inheritance to taxes impact the lives of Griffin’s heirs?
These kinds of cases are a reminder to us all that we can’t just be planners; we must also be able to execute. It’s important to attend to detail, particularly when doing estate planning for a client. When the will and trust administration actually kick in, the client is likely no longer alive to clarify, cure or mitigate the mistakes of the advisor. Minor miscues can balloon into million-dollar mishaps.
Steve Parrish, JD, RICP, CLU, ChFC, AEP, is Professor of Practice and Scholar in Residence at The American College of Financial Services. With over 45 years’ experience as an attorney and financial planner, Parrish frequently addresses the financial challenges of individuals, business owners, and executives nationwide.
