Alumna Writes Article on Taxes and Trusts
By Stephen M. Breitstone and Rachel Jesselson
The type of testamentary trust commonly known as a 'QTIP' trust is frequently used to protect children from being disinherited, or otherwise disadvantaged, by a surviving spouse beneficiary.
Pursuant to § 2056(b)(7) of the Internal Revenue Code (the Code), a testamentary qualified terminal interest property (QTIP) trust allows a decedent to, in effect, 'rule from the grave,' so to speak, through a testamentary grant to a surviving spouse of the use and enjoyment of property for life, while prohibiting the surviving spouse from determining the ultimate disposition of those assets. [FN1]
This technique is extremely valuable where there are children from a prior marriage, fears of remarriage or other relationships, or where there is potential hostility between the surviving spouse and the children.
However, as illustrated in the recent decision of Kalikow v. Estate of Kalikow, file no. 340361 (unpublished March 28, 2007), a surviving spouse beneficiary of a testamentary QTIP still may have the potential to cause mischief for the remainderperson whom the QTIP trust was intended to protect. This is because the executors of the will of the surviving spouse are responsible for and control the estate tax filings relating to the QTIP trust upon the death of the surviving spouse. Moreover, the surviving spouse may, through the dispositive scheme in his or her will, create incentives for the persons in control of the estate tax filings to overvalue QTIP assets and thus inflate estate tax obligations to be borne by the remaindermen of the testamentary QTIP trust.
The potential for mischief results from the distinction between the surviving spouse's 'probate estate' and 'taxable estate.' The quid pro quo for allowing the assets of the QTIP trust to escape taxation in the estate of the first spouse to die is that upon the death of the surviving spouse, all of the assets of the trust are subject to estate tax pursuant to § 2044 of the Code. This treatment creates a disconnect between the probate estate and the taxable estate. On the one hand, the QTIP trust (as an expired life estate) is not part of the surviving spouse's probate estate. There is nothing left to probate. On the other hand, the QTIP assets are part of the surviving spouse's 'taxable' estate as a result of the fiction of 'inclusion' created by § 2044 of the Code.
In a harmonious familial setting, there are excellent tax planning opportunities that may be employed between the surviving spouse and the testamentary QTIP trust. These opportunities can be employed to significantly reduce the overall estate tax burden of these assets. For example, although Code § 2207A(a)(1) imposes the primary responsibility for federal estate taxes on the assets of the QTIP trust or its beneficiaries (not on the probate estate), the tax apportionment clause of the will of the surviving spouse may direct that probate estate bear the tax burden. See Code § 2207A(a)(2). Where the QTIP trust is exempt from the generation-skipping transfer tax, this type of direction can reduce overall transfer tax burdens upon the remaindermen of the QTIP trust.
In the case where the surviving spouse QTIP beneficiary does not choose to leave his or her probate estate to the QTIP remaindermen, an anomaly results from the fact that the executors of the surviving spouse's probate estate control the estate tax filings of the QTIP trust even though the estate will have no responsibility for the payment of the resulting taxes and the executors owe very limited fiduciary duties to the QTIP remaindermen in their capacities as executors.
This phenomenon can create considerable tension between the executors and the QTIP remaindermen.
Moreover, the dispositive scheme of the surviving spouse may by its very nature, impose conflicting roles upon the executors with respect to the estate tax filings. These conflicts can put the remainderpersons of the QTIP at considerable tax peril by leaving them with nobody to advocate for their position. Questions can arise as to whether the executors of the surviving spouse's estate owe a duty to mitigate estate taxes of the QTIP trust assets, and as to whether such a duty, if it exists, is trumped by a duty to maximize the assets of the probate estate. The answers to these questions can have a major financial impact upon the QTIP trust remainderpersons.
This point is well-illustrated in the recent decision by Surrogate John B. Riordan of Nassau County, in Kalikow. In that case, the bulk of the decedent's probate estate was earmarked for a charitable foundation she created. Decedent's taxable estate included an interest in a family limited partnership (FLP I) which held rental real estate. The remaining interests were held by the decedent's children.
Decedent's will granted to her children an option to purchase her interests in FLP I at a price based upon the value of the shares as 'fixed and determined' for federal estate tax purposes. However, decedent's taxable estate also included the assets of a QTIP trust containing a limited partnership interest in another family limited partnership (FLP II) which held rental real estate similar in character to that held by FLP I. The remainderpersons of the QTIP trust were continuing trusts for the benefit of decedent's children and grandchildren.
In Kalikow, petitioners alleged that a potential conflict of interest of the nature discussed in the preceding paragraphs arose in connection with the preparation and filing of the decedent's estate tax return.
On the one hand, if the executors advocated high values for the probate estate's assets, they could potentially increase the value of the charitable bequest should the children exercise the option to purchase decedent's interest in FLP I. As these assets would be distributed to charity, the estate tax charitable deduction would operate to prevent any resultant increase in estate tax. (Code § 2055(a)).
On the other hand, assuming the executors used consistent valuation methods for FLP I and FLP II (held by the QTIP trust), increasing the value of the QTIP trust assets would result in a substantially greater estate tax, which was alleged by the representatives for the remainderpersons of the QTIP trust to be in direct conflict with the executors' duty to mitigate estate taxes. However, petitioners could not exercise any influence over the valuation of the trust assets on the estate tax return, since federal law clearly requires that the executors, and not the beneficiaries or the trustees of the QTIP trust, file the estate tax return. See Code § 6018(a)(1). Moreover, although the QTIP's representatives may have had remedies in an accounting proceeding, they claimed that the damages could have been greater than what they could hope to recover (assuming they could prove them), in an accounting proceeding.
Just weeks prior to the due date for filing the estate tax return, decedent's children, by order to show cause for preliminary injunctive relief, brought an action seeking limited letters pursuant to SCPA 702(8) and 702(10) permitting them to prepare and file the portion of the estate tax return relating to the QTIP assets.
The court granted this relief pending a hearing scheduled for a date subsequent to the due date for the filing of the estate tax return to determine whether to make permanent the relief granted, including the power to supplement and to defend the return.
However, the executors dropped their objections to the court's grant of relief to the children before the hearing date. It should be noted that the matter was resolved before there was a factual determination by the court as to whether the executors in fact acted upon the conflict or otherwise committed any wrongdoing.
In fashioning the appropriate relief, the Surrogate's Court had to grapple with the issue of the extent to which a local court could alter the federal procedural scheme for the filing of an estate tax return. [FN2] The Code clearly required the executors of the surviving spouse's estate, and not the beneficiaries or representatives of the QTIP trust, to file and defend the estate tax return. Nevertheless, the court used its equitable powers to bifurcate the role of executor: by giving a portion of that role to the representatives of the QTIP trust the court was able to grant the power over that portion of the return to persons who were not named as executors of the surviving spouse's estate under the will, without violating the letter or spirit of the federal tax scheme.
The court found authority to grant this extraordinary relief pursuant to § § 702(8) and 702(10) of the New York Surrogate's Court Procedure Act (SCPA). SCPA 702(8) provides that limited letters may be issued, 'in the discretion of the court, to represent the estate in a transaction in which the acting fiduciary could not or should not act in his or her fiduciary capacity because of a conflict of interest.' SCPA 702(10) provides that limited letters may issue for 'any other purpose or act deemed by the court to be appropriate or necessary in respect of the affairs of the estate, the protection thereof or to the proper administration thereof.'
At the initial hearing, the preliminary executor respondents contended that it was their duty to obtain fair and objective valuations for both categories of assets, the estate assets earmarked for charity and the taxable QTIP assets. They also contended that they were required to use valuations for both categories of assets that were 'consistent.' The petitioners' representatives argued that the duty to maximize the charitable probate assets and the duty to mitigate the estate taxes of the QTIP assets were in conflict. Moreover, they claimed that the executors had chosen to err on the side of favoring their duty to maximize the charitable assets.
It is well-established that in making tax elections, executors are obligated to mitigate the overall tax burden borne by the estate and to act impartially. See Matter of Rappaport, 121 Misc2d 447, (Sur. Ct. Nassau County 1983). In the Kalikow decision, the court cited In Re James' Estate, which noted that, 'where an executor or a trustee acts merely as a bystander while two beneficiaries attempt to adjust as between themselves matters...the fiduciary may not be called upon to aid or advise either disputant. But where he affirmatively undertakes to deal with one beneficiary for the benefit and profit of another he cannot be unmindful of his duty of loyalty to all beneficiaries and of his duty to effectuate the terms of his trust. Both beneficiaries are entitled to expect impartiality and even handed justice from the fiduciary.' 86 NYS2d 78, 89 (Sur. Ct. New York County 1948).
The court in Kalikow refused to rule as a general matter that in all cases where similar potential conflicts exist, the executors should be relieved from their duties to file the estate tax return relating to the QTIP trust. However, the court did grant limited letters to the petitioners which enabled them, as the persons responsible to pay the tax, to prepare and file the return. The court reserved for a later decision whether to grant to the petitioners the right to supplement and to defend the return. Prior to conducting a hearing on the latter issues, the parties resolved the matter.
The decision in Kalikow was narrowly crafted. The court noted that the mere existence of a conflict of interest or valuation dispute would not provide the basis for the type of relief granted in that case. However, the substance of the court's decision indicates that it may interpose this type of relief where it is demonstrated that a fiduciary in a conflicted role chooses to affirmatively promote the interests of one class of beneficiaries at the cost of the interests of another, and where another party could suffer irreparable harm (that could not be remedied in a surcharge proceeding) as a result of the fiduciary's actions.
Stephen M. Breitstone heads the tax law group at Meltzer Lippe Goldstein & Breitstone. Rachel Jesselson, an associate at the firm, specializes in trusts and estates, tax-exempt organizations, and estate and charitable planning.
FN1. Section 2056(b)(7) permits the executors of the decedent's estate to make an election with respect to this certain trusts to qualify those trusts for the estate tax marital deduction, even though the interest left to the surviving spouse would otherwise constitute a nondeductible terminable interest (such interests generally do not qualify for the estate tax marital deduction) (2056(b)(1)).
FN2. In Burnet v. Harmel, the U.S. Supreme Court noted that, 'It is the will of Congress which controls, and the expression of its will in legislation, in the absence of language evidencing a different purpose, is to be interpreted so as to give a uniform application to a nation-wide scheme of taxation...[citations omitted].... State law may control only when the federal taxing act, by express language or necessary implication, makes its own operation dependent upon state law....' 287 US 103, 110 (1932).
Reprinted with permission from the June 14, 2007, edition of the New York Law Journal (c) 2007 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.