Code Section 2519 is a notoriously difficult section to apply. In 2009, I wrote on article on it for Estate Planning, and ever since I’ve been providing a lot of assistance to others on its operation. So I am always interested when a new Section 2519 opinion comes out.
In Estate of Kite, the Tax Court issued an erroneous opinion as to the applicability of Section 2519, at least in my opinion. In Kite, a husband passed away, and assets were funded into a QTIP trust for his wife. Before the wife’s death, some or all of the QTIP trust assets were transferred to a family partnership. Later, the trust was terminated, and all of its assets (including the family partnership interests) were transferred to the wife. She then sold those partnership interests to family members in exchange for a private annuity two days later. She later died before any annuity payments were received, and thus the sold QTIP assets avoided taxability in the wife’s estate based on applicable private annuity rules.
The case is helpful in context of deferred private annuities – the Tax Court upheld the exclusion of the sold assets from the wife’s gross estate. However, the Court also ruled that the distribution of the trust assets to the wife and the sale for a private annuity should be integrated under the step transaction doctrine. Once the transaction was combined, the Court found that the wife had disposed of her income interest in the QTIP trust in the private annuity sale, and thus triggered a Section 2519 gift tax on the value of the remainder interest in the QTIP.
This conclusion is suspect on more than one level:
a. First, if the Court was to disregard the transfer first to Mrs. Kite, then what occurred was a sale BY THE TRUST of its assets for a private annuity. The Court, in addressing both a reinvestment of trust assets into the family partnership and other sales of trust assets to family members, acknowledges that a sale by the trust itself is not a Section 2519 disposition of an income interest since the income interest continues in the newly acquired asset. To say that Mrs. Kite disposed of her income interest in the sale is somewhat specious, since the sale was of all of the trust assets without regard to the value of the income interest alone.
b. Second, and more importantly, the Court applies a technical and strained reading of the statute to achieve a result that was never intended under Section 2519. Section 2519 is intended to avoid a surviving spouse’s estate from avoiding estate and gift tax on assets received by that spouse in a QTIP that escaped taxation at the first spouse’s death by reason of the marital deduction. That is, the first spouse’s estate got an estate tax deduction (and thus no estate taxes were imposed) on assets going into the QTIP trust. However, Code Section 2044 imposes a cost of that tax avoidance – inclusion of the QTIP trust assets remaining at the death of the surviving spouse in his or her estate. Section 2519 was passed as a backstop to Section 2044 to trigger the tax in transactions that would in effect bypass the later taxation of the QTIP trust assets at the surviving spouse’s death. In this case, the Court has instead subjected the surviving spouse to double taxation. To illustrate this, assume that Mrs. Kite received all of the trust assets, and they were worth $1 million. Let’s also assume that the value of the remainder interest is $600,000, and that Mrs. Kite sold the $1 million in assets she received from the trust for $1 million. If Mrs. Kite had died while the $1 million was still in the trust, her gross estate would include the $1 million under Section 2044. When Mrs. Kite received the $1 million in assets, if she had died the day after the full value of the trust assets would still be in her gross estate under Section 2033 (per her direct ownership of them), and thus no estate taxes on the QTIP trust assets were avoided on the termination of the QTIP trust. This is why Section 2519 does not generally apply to principal distributions to a surviving spouse from a QTIP trust. The fact that Mrs. Kite then sells those assets for $1 million in cash does not change the result – she still has $1 million in assets subject to estate tax at her death. Now, if the termination of the QTIP trust and the sale results in gift tax on the $600,000 remainder interest as the Tax Court tells us it does, that $600,000 is taxed twice. First, under Section 2519, and then when Mrs. Kite dies. Something is very wrong here for that to happen.
Now, in Kite, there was no double taxation. But that is because the private annuity functioned to exclude the value of the sold assets and the annuity from Mrs. Kite’s gross estate. If instead Mrs. Kite had sold assets for cash or a promissory note valued at $1 million, or had lived long enough to receive the annuity payments that the actuarial tables predicted, and then she died, this double taxation would show up. The fact that the private annuity functioned to avoid estate tax on this instance is a function of the tax provisions that relate to private annuities and not Section 2519. Indeed, the Tax Court opinion gives no indication that the private annuity aspect of the sale would or should change the Section 2519 result it thought was proper, and Kite as written should apply to all sales in this circumstance, not just sales by deferred private annuity (although perhaps one could argue that it only applied to deferred private annuity sales).
The case is also bad news since it muddies the waters if a surviving spouse receives any distributions from a QTIP trust and then sells the received asset. At what point in time will the sale be far enough away from the distribution date to avoid Kite? Since Section 2519 applies to a disposition of any part of the income interest, the fact that the spouse did not receive and/or sell a substantial portion of the QTIP trust assets would not avoid the applicability of Section 2519.
There is also another facet of the case that raises a question for me. It appears that in 1997, distributions of QTIP trust assets were made to relatives of Mrs. Kite, and these were reported as gifts. If in fact such distributions were made, this should have been characterized as a disposition of a part of the income interest of Mrs. Kite (via a reduction in trust assets that are there to produce income for the income interest holder) and triggered Section 2519 at that earlier time. If Section 2519 was triggered on that earlier date, it could not have been triggered again at the time of the distribution and sale to Mrs. Kite in 2001, and since a gift tax return was filed in 1997 it would appear that the statute of limitations for additional tax due in 1997 (as would be incurred in Section 2519 applies in 1997 to the full value of the trust) should likely be closed. Thus, Code Section 2519 should not have applied in 2001.
Kite is not all bad news for taxpayers. It provides some favorable findings and rulings on the use of deferred annuities to avoid estate taxes (assuming the annuitant does not live to his or her life expectancy). It also confirms that sales of assets by a QTIP trust do not trigger Section 2519.
I used to tell people raising questions whether Section 2519 applied to a particular set of facts that the best guide for Section 2519 is whether there is an opportunity in the current transaction to avoid estate tax on some or all of the remainder interest assets of the QTIP trust – if yes, then Section 2519 likely applies. By failing to take the purpose of Section 2519 into account in Kite, and even worse, subjecting similarly situated taxpayers to double taxation, the Tax Court did not make this “gut check” and thus may have missed the mark on this one.
Estate of Virginia Kite v. Comm., TC Memo 2013-43