Toggling Gross Estate Inclusion On and Off: A Powerful … · · 2017-02-21Toggling Gross Estate...

Alongstanding, if curious, fea-ture of the U.S. gift and estatetax system—lately celebrat-ing its 100th anniversary1—is

that the same property whose trans-fer was subject to gift tax duringlifetime may be subject to estate taxat the transferor’s death. To takea classic example, suppose that afather irrevocably transfers to hisdaughter a remainder interest in hisresidence, but retains a life estatefor himself. The father therebymakes a taxable gift of the remain-der, and will be liable for any gifttax that may be due.2 In addition,at the father’s death, the residencewill be included in his gross estatefor estate tax purposes under Sec-tion 2036(a)(1).

Fortunately, the estate tax com-putation procedures, by effective-ly purging the gift from the trans-fer tax base and allowing a creditfor gift taxes payable,3 prevent dou-ble taxation of the same gift. Thatsaid, gross estate inclusion doescause the residence to be taxed at

its date-of-death value rather thanits value at the time of the gift.Revaluation rather than double tax-ation, in other words, is the con-sequence when property transferredduring lifetime is pulled back intothe donor’s gross estate at death.

As most property tends to appre-ciate in value, wealthy taxpayers typ-ically plan to avoid gross estate inclu-sion of lifetime property transfers.Suppose, for example, that the father

owns shares of stock that will appre-ciate in value from $1 million to $5million by the time of his death. Ifthe father makes a gift of the stockto his daughter when it is worth $1million, and the stock passes outsideof his gross estate, he will be subjectto gift tax on only $1 million. Butif instead the stock is pulled backinto the father’s gross estate at death,an estate tax will be imposed on $5million. Lifetime gifts that escapeestate tax at death, in short, freezevalue as of the time of the gifts.

For that very reason, however,taxpayers sometimes prefer to haveproperty transferred during life-time included in their gross estatesat death. Suppose, for example, thatthe father makes a gift in trust ofstock worth $5 million at the timeof the gift. In this scenario, by thetime of the father’s death, the stockhappens to decline in value to $1 million. If the stock is includedin the father’s gross estate at death,estate tax will be imposed on the$1 million value, and the $5 mil-

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Toggling Gross EstateInclusion On and Off: A Powerful Strategy

Creative planning increases the opportunity to balance estate tax savings of excluding property from an estate with income tax savings of estate inclusion.

AUSTIN W. BRAMWELL AND ELISABETH O. MADDEN

AUSTIN W. BRAMWELL is a partner in the Trusts &Estates Group of Milbank, Tweed, Hadley & McCloyLLP and an adjunct professor of law at New York Uni-versity School of Law, where he teaches incometaxation of trusts and estates. He is a Fellow of theAmerican College of Trusts and Estates Counsel. ELISABETH O. MADDEN is a vice president of Rockefeller Trust Company, N.A., where she focus-es on the administration of trusts and estates for pri-vate clients. The authors acknowledge with gratitudethe comments of Prof. David Herzig, Jerry Hesch, Elizabeth Munson, and Sean R. Weissbart. The viewsexpressed herein are the authors’ own; have beenprovided for informational purposes only; and are notintended as legal, tax, estate planning, or other pro-fessional advice. Copyright ©2017, Austin W.Bramwell and Elisabeth O. Madden.

lion gift will effectively be purgedfrom the wealth transfer tax base.Gross estate inclusion in this caseis more efficient than having theproperty pass free of estate tax.4

Another reason that taxpayersmay prefer gifts made during life-time to become subject to estatetax at death is that the income taxsavings from gross estate inclusion,thanks to the “step up” in basis atdeath for property acquired from adecedent, may exceed any estate taxsavings achieved from setting a fixedvalue.5 Suppose that the father owns

100 ABC Corp shares having a valueof $5 million but a cost basis of $0.If the father simply holds onto theshares, they will qualify for a step-up in basis at his death. Assuming(for simplicity) a flat capital gainstax rate of 23.8% and that the valueof the shares remains $5 million, thebasis step-up saves $1,190,000 ofincome tax, if the shares are soldafter the father’s death.

But suppose instead that thefather makes a gift of the shares tohis daughter during his lifetime. Ifthe shares appreciate after the dateof the gift, the daughter receives thebenefit of the appreciation free ofany further gift or estate tax. At a40% estate tax rate, the savings fromeach $1 million of post-gift appre-ciation is $400,000. Notice, how-ever, that $400,000 of estate tax sav-ings is less than half of the$1,190,000 income tax savings thatcould be achieved simply by havingthe father hold onto the shares dur-ing his lifetime. For the estate taxsavings from the father’s gift to

exceed the income tax cost of los-ing the step-up in basis, the sharesmust appreciate approximately246.91%, or from a value of $5 mil-lion to a value of $12,345,679.6 Ifthat appreciation fails to occur, itwould be preferable, assuming thatthe shares will be sold, to have theshares pulled back into the father’sgross estate at death.

In short, including property trans-ferred during lifetime in the dece-dent’s gross estate may or may notbe tax efficient, depending on thevalue of the property at death andits cost basis. Ideally, taxpayerswould be able to monitor their pastgifts and decide whether to triggergross estate inclusion or not. Putanother way, taxpayers would liketo toggle gross estate inclusion onand off, depending on which resultis preferable. Strangely, however,there is very little literature on tog-gling strategies.7 This article exploresthe strategies that taxpayers mightwish to consider in order to turngross estate inclusion on and off.

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E S T A T E P L A N N I N G M A R C H 2 0 1 7 V O L 4 4 / N O 3

1 For historical retrospectives, see McCaffreyand McCaffrey, “Our Wealth Transfer Tax Sys-tem: A View From the 100th Year,” 41 ACTECL. J. 1 (Spring 2015); Christerson, “The EstateTax at 100,” 42 Estate Planning Review 165(2016); and Kaufman “On the CentennialAnniversary of the Estate Tax,” 43 ETPL 38(September 2016).

2 Under the special valuation rules of Section2702, the value of the gift is deemed to beequal to the entire value of the property.

3 Any gift tax payable on the gift of the remain-der is effectively restored in the form of a cred-it under Section 2001(b)(2). Any unified cred-it used up by the gift is likewise effectivelyrestored, as the gift is not treated as a “adjust-ed taxable gift” as defined in the flush lan-guage of Section 2001(b).

4 An interesting question is whether the sameresult applies if the decline in value is causedby distributions rather than negative investmentreturns. For example, suppose that the fathermakes a completed gift in trust of $5 million,of which all but $1,000 is distributed to bene-ficiaries during his lifetime. At his death, theremaining $1,000 is included in the father’sgross estate under Section 2038(a). Logicallyand as a matter of policy, it would seem thatonly the portion of the trust that was not dis-tributed during lifetime should be purgedfrom the wealth transfer tax base at death; thebalance of the $5 million gift should be addedto the computation of estate tax as an adjust-ed taxable gift as defined in Section 2001(b).

5 Section 1014(a) generally provides (subjectto exceptions, such as for income in respectof a decedent under Section 1014(c)) that the

basis of property inherited or acquired froma decedent is equal to its fair market valueat death, or its value on the alternate valua-tion date, if an alternate valuation date elec-tion is made under Section 2032. By Section1014(b)(9), most property that is included ina decedent’s gross estate for estate tax pur-poses is deemed to have been acquired froma decedent and qualifies for the change inbasis under Section 1014(a). The change inbasis does not necessarily result in anincrease or “step up.” As most property tendsto appreciate in value, however, the changein basis is commonly referred to, including inthis article, as a “step up” in basis.

6 This computation ignores, for simplicity, theeffect of the gift tax annual exclusion underSection 2503.

7 For one example of an article advocating tog-gling, see Weissbart, “Estate Planning Strate-gies for the Young and Wealthy,” 41 ETPL28 (February 2014). See also McCaffrey, “TaxTuning the Estate Plan by Formula,” 33 U. ofMiami Law Center’s Philip E. Heckerling Insti-tute on Estate Planning 403 (1999) (propos-ing a formula strategy, discussed below inthe text); Blattmachr and Zeydel, “RegrettingRecent Estate Tax Planning Arrangements?,”42 ETPL 3 (October 2015).

8 For an example of a failed toggling strategy,see Estate of Sommers, TCM 2013-8 (reject-ing taxpayer’s argument that assignmentsduring lifetime were incomplete for gift taxpurposes until blanks were filled in).

9 Reg. 25.2511-2(b); see also Sanford’s Estate,308 U.S. 39, 23 AFTR 756 (1939).

10 Reg. 25.2511-2(g).

11 As the Supreme Court pointed out in Sanford’sEstate, supra note 9, a gift’s being incompletefor gift tax purpose does not prevent the gov-ernment from ever taxing the transfer of theproperty, for, if transfers “are not taxed asgifts they remain subject to death taxes ... andthe Government gets its due.”

12 Reg. 25.2511-2(d). 13 See Estate of Alexander, 81 TC 757 (1983),

aff’d in unpub. op. (CA-4, 1985); Reg.20.2038-1(a); Lober, 346 U.S. 335, 44 AFTR467 (1953).

14 Rifkind, 5 Cl. Ct. 362, 54 AFTR2d 84-6453(1984).

15 Estate of Halbach, 71 TC 141 (1978) (hold-ing that a disclaimer of an interest is equiva-lent to a transfer or relinquishment).

16 Section 2038(a) has its own, separately stat-ed three-year look-back rule, which appliesif taxable powers are renounced within threeyears of and in contemplation of death.

17 A renunciation or other elimination of a tax-able power could itself be a taxable gift. Forexample, suppose the father makes a gift ofproperty to an irrevocable trust, and retainsthe power to determine which of his descen-dants will receive the income of the proper-ty. The father’s gift is incomplete as to income(although the income interest will be valuedat zero under Section 2702). A renunciationof the power to determine who will receive theincome of the trust will complete the gift of theincome interest. (If Section 2702 applied tothe original gift in trust, a special rule preventsdouble taxation of the gift of the income.)

Including propertytransferred duringlifetime in thedecedent’s grossestate may or may not be tax efficient,depending on thevalue of theproperty at deathand its cost basis.

Obstacles to togglingIf toggling gross estate inclusion onand off is possible at all, it is noteasy.8 For one thing, the opportu-nity to pull transferred propertyback into a donor’s gross estate aris-es only if the donor makes a com-pleted gift for gift tax purposes. Adonor does not make a completedgift, however, unless the donor, inthe words of Treasury regulations,“has so parted with dominion andcontrol as to leave him no powerto change its disposition.”9 Therelinquishment of dominion andcontrol eliminates many (althoughnot all) of the possible ways in whichthe transferred property can beincluded in the donor’s gross estate.

For example, suppose that thefather transfers property in trustbut retains the power, as trustee, todecide who, out of the class of trustbeneficiaries, will receive distribu-tions of income or principal. Sucha retained power over distributions,if not limited by an ascertainablestandard,10 prevents a completedtaxable gift from occurring. In addi-tion, the trust property will beincluded in the father’s gross estateat death under Sections 2036(a)(2)and 2038(a)(1). As the propertywould have been included in thefather’s gross estate had he notmade the transfer at all, the trans-fer in trust does not create anopportunity to avoid gross estateinclusion.11

Suppose instead that the fatherappoints an independent trusteewho has the power to make dis-tribution decisions. The father’s giftin that case is complete for gifttax purposes. But this time theopposite problem arises: Althoughthe property, without further plan-ning, will pass outside of thefather’s gross estate at death, thatmay not, as discussed above, alwaysproduce the optimal result. With-out some possible gross estate inclu-sion trigger, the property will pass

outside the father’s gross estate,even if the father and his familywould prefer the property to besubject to estate tax.

As discussed in further detailbelow, it is possible for the donorto retain (or to possess at death)powers that will cause gross estateinclusion yet not prevent a com-pleted gift. Broadly speaking, thesepowers come in three types:

1. Retained or reserved powers,or powers held by the donor atthe time of the transfer.

2. Automatically triggered powers,or powers that automaticallyspring into being at death inorder to cause gross estate inclu-sion, if that is the right result.

3. Conferred powers, or powersthat could be given to the donorby the time of his death in orderto cause gross estate inclusionunder Section 2038(a).

These three types of powers, andthe challenges of using them to tog-gle gross estate inclusion on andoff, are discussed below.

Toggling inclusion on and off with retained powersAs discussed, a donor may make acompleted gift, yet still retain pow-ers that will cause the property tobe pulled back into his or her grossestate at death. For example, sup-pose that a father creates an irrev-ocable trust for the sole benefit ofhis daughter, but retains the abili-ty to distribute income and prin-cipal to the daughter at such timeas the father determines. Thefather’s gift, despite the retainedpower over the timing of the daugh-ter’s enjoyment, is complete for gifttax purposes.12 Nevertheless, hisretained power will cause grossestate inclusion at his death underSections 2036(a)(2) and 2038(a).13

Once a gift is made in a mannerthat, without further planning, willcause the transferred property to be

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M A R C H 2 0 1 7 V O L 4 4 / N O 3 T O G G L I N G I N C L U S I O N

included in the donor’s gross estate,the only way to avoid gross estateinclusion is to eliminate the retainedtaxable rights and powers. Forexample, a donor could relinquishthe powers that would otherwisecause gross estate inclusion, such asby resigning from office14 or dis-claiming the taxable power.15 Aneffective relinquishment would elim-inate the taxable retained powers.But that may be a hollow victory:Section 2035(a) provides that, if aninterest or power causing grossestate inclusion under Sections 2036,2037, 2038, or 2042 is transferredor relinquished within three yearsof death, the property will still beincluded in the decedent’s grossestate.16 A relinquishment, there-fore, will cause the trust property topass outside of the gross estate onlyif the donor survives three yearsfrom the time of the relinquish-ment.17 That three-year restrictionmakes renunciation of retained pow-

ers an inflexible tool for toggling offgross estate inclusion.18

That said, it may be possible,through careful planning, to avoidthe three-year rule of Section2035(a). It seems that a “transfer”or “relinquishment” under Section2035(a) does not occur withoutsome affirmative or voluntary actby the individual whose power istransferred or relinquished.19 Thus,as the IRS has acknowledged innon-binding rulings,20 terminationof a right to property in accordancewith its terms, such as a right thatautomatically terminates after afixed period of years, does not trig-ger a three-year gross estate inclu-sion period under Section 2035(a).

Likewise, the termination of apower as a result of events outsidethe transferor’s control should notbe viewed as a transfer or relin-quishment within the meaning ofSection 2035(a).21 Thus, even ifthe transferor does retain a tax-

able power under Section 2036(a)(2)or 2038(a), it may be possible toavoid the three-year rule of Sec-tion 2035(a) (and the separately stat-ed three-year rule of Section2038(a)) if the power could be elim-inated by a third party. For exam-ple, the donor could give an inde-pendent party the power to eliminatethe transferor’s distribution pow-ers. The three-year inclusion rule ofSection 2035(a) may in that case notbe triggered if the donor’s power iseliminated, even if within three yearsof the donor’s death.

As yet, it remains unclearwhether this position will prevail.22

Furthermore, even if it is true, inprinciple, that Section 2035(a) isnot triggered where a power isexpunged rather than relinquished,the IRS could argue that the dece-dent relinquished the power in sub-stance, based on circumstances sug-gesting that the power would beeliminated at the request (even if

non-binding) of the decedent.23 Forthat reason, an attempt to avoidthe relinquishment requirement ofSection 2035(a) by having an inde-pendent party eliminate the donor’sretained powers is not certain towork.

Retained powers that triggergross estate inclusion are unat-tractive for other reasons as well.First, if the donor retains such apower, the donor will be prevent-ed under Section 2642(f) from allo-cating generation-skipping trans-fer (GST) exemption to the transferfor GST tax purposes. Second,thanks to a technical defect in Sec-tion 2001(e), if the donor and thedonor’s spouse elect to split theirgifts for the year under Section2513, the donor’s spouse’s gift taxexclusion amount may be wastedif it turns out that the property isincluded in the donor’s grossestate.24 Thus, retained powersshould not be used as a toggling

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18 The donor or a family member could acquirelife insurance in order to shift the risk thatthe father will die within three years. At a min-imum, however, such insurance, even if avail-able, will add to the costs and complexity ofattempting to turn off gross estate inclusionby renunciation.

19 Cf. Estate of diMarco, 87 TC 653 (1986)(“[T]here can be no act of transfer unlessthe act is voluntary and the transferor hassome awareness that he is in fact making atransfer of property, that is, he must intend todo so”); Harris, 340 U.S. 106 (1950) (requir-ing that a transfer be “voluntary” for gift taxto apply).

20 Ltr. Ruls. 9109033 and 9032002. Under Sec-tion 6110(k), private letter rulings may notbe cited as precedent.

21 Ltr. Rul. 9032002. 22 In TAM 199935003, a grantor’s interest in a

grantor-retained income trust was commut-ed by the trustee, who terminated the grantor’sretained interest by paying out to the grantorcash in an amount equal to the actuarial valueof the grantor’s interest. The IRS rejectedthe estate’s argument that Section 2035(a)did not apply to the commutation. Accord-ing to the IRS, “although the Decedent did notformally initiate the commutation, the exer-cise of the power by the trustee was consis-tent with Decedent’s intent and was author-ized, if not implicitly directed, by theDecedent.” Consequently, the commutationwas a voluntary transfer by the grantor, andSection 2035(a) applied.

23 Cf. TAM 199935003 (ruling that a commuta-tion of the decedent’s interest was a transferwithin the meaning of the Section 2035(a) inpart on the grounds that the purpose of thecommutation was to avoid gross estate inclu-

sion). The concept of a right existing basedon an understanding between the transferorof property and another is found in the regu-lations under Section 2036(a)(1). Reg.20.2036-1(c)(1)(i). See, e.g., Estate of Lin-derme, 52 TC 305 (1969); Paxton, 86 TC785 (1986). The concept also applies, in theIRS’s view, to the power to vote stock of a con-trolled corporation under Section 2036(b).See Rev. Rul. 80-346, 1980-2 CB 271; Prop.Reg. 20.2036-2(c). Finally, in the case of trans-fers made on or before 6/22/1936, a right isconsidered to have been retained by thedecedent if there was an understanding,express or implied, that the power would beconferred on the decedent. Reg. 20.2038-1(c). As yet, it is unclear whether the conceptapplies in the Section 2035 context.

24 Section 2001(e) of the Code provides that, ifproperty transferred by a decedent’s spouseis included in a decedent’s spouse’s grossestate under Section 2035, and the decedentelected to split gifts with the decedent’sspouse, the decedent’s deemed gift is notconsidered an adjusted taxable gift; thus, itis effectively purged from the gift and estatetax base. If the property is included in thedecedent’s spouse’s gross estate underanother section, however, no similar relief isavailable. Even if property is included in thedecedent’s spouse’s gross estate under Sec-tion 2035, the relief of Section 2001(e) is notavailable if the decedent dies first and theadjusted taxable gifts of the decedent becomefinally determined for estate tax purposesbefore there is a chance to invoke Section2001(e). Cf. Rev. Rul. 81-85, 1981-1 CB 452.

25 For more on this technique, see McCaffrey,“Tax Tuning the Estate Plan by Formula,” 33U. of Miami Law Center’s Philip E. HeckerlingInstitute on Estate Planning 403 (1999).

26 Reg. 20.2038-1(b).27 Reg. 20.2036-1(b)(3). 28 Reg. 20.2036-1(b)(3). 29 Authority interpreting the scope of the regu-

lation exception is scarce. 30 Another problem, perhaps, is that the formu-

la inclusion strategy relies on a regulation, Reg.20.2036-1(b)(3), whose viability remains untest-ed. The rule stated in that regulation—that Sec-tion 2036(a)(2) does not apply to powers whichdo not affect the enjoyment of property duringthe decedent’s lifetime—is arguably at oddswith the words of the statute, which do not con-tain a limitation to powers that can affect onlythe enjoyment of income during the decedent’slifetime. (On the other hand, perhaps the ruleis based on the statutory condition that Sec-tion 2036(a) applies only if a taxable poweror right is retained for life, for a period that doesnot in fact end before death, or for a period notascertainable without reference to the trans-feror’s death. The regulation’s view may be thatif a power does not become exercisable untildeath, then it does not fall within the time framesspecified by the statute; rather, it occurs onlyafter the requisite time frames have ended.)Conceivably, the IRS could attempt to disavowthe rule in a litigation. Burke, 504 U.S. 299,69 AFTR2d 92-1293 (1992) (Scalia, J. con-curring) (“[W]hile agencies are bound by thoseregulations that are issued within the scope oftheir lawful discretion ... they cannot be boundby regulations that are contrary to law.”).

31 McCaffrey, “Tax Tuning the Estate Plan byFormula,” 33 U. of Miami Law Center’s PhilipE. Heckerling Institute on Estate Planning 403(1999). The reason for caution is that a powerof sale could be deemed a Section 2038(a)power in the context of the formula inclusionstrategy.

strategy if the donor and thedonor’s spouse wish to split gifts.

Triggering inclusion automatically by formulaAnother technique for triggeringgross estate inclusion, if desirable,is for the donor to transfer prop-erty to an irrevocable trust, butretain control over only so muchprincipal as will lead to an optimaltax result.25

Example. A father makes a gift intrust for his descendants of $5 mil-lion worth of ABC stock having abasis of zero. The trust providesthat, at the father’s death, the trustwill pay over the shares to thefather’s estate, unless the value ofthe shares exceeds a thresholdamount. The threshold amount isexceeded, according to a formulaset forth in the trust instrument,only if the estate tax savings fromavoiding gross estate inclusionexceeds the income tax cost to thebeneficiaries of losing the step-upin basis.

• If the shares fail to appreciate,the estate tax savings of avoid-ing gross estate inclusion willbe zero, and the shares, inaccordance with the formula,would be paid over to thefather’s estate at death (andthereby qualify for a step-upin basis).

• By contrast, if the shares (forinstance) quadruple in value,the estate tax savings of pass-ing the appreciation free of

estate tax would exceed thecost of losing the step-up inbasis. Thus, none of the shareswould be paid over to thefather’s estate. Consequently,Section 2038(a)(1) would notcause gross estate inclusion, asthat section does not apply tocontingent powers not actuallypossessed at death.26

Section 2036(a)(2), in contrastto Section 2038(a), does cause grossestate inclusion if the decedentretained a contingent right to deter-mine who will enjoy the incomefrom property transferred duringlifetime.27 Treasury regulations,however, take the position that theSection does not apply to a powerover the property “which does notaffect the enjoyment of income dur-ing the decedent’s lifetime.”28 Pow-ers exercisable only at death, evi-dently,29 do not cause gross estateinclusion under Section 2036(a)(2).As the possible return of transferredproperty to the transferor’s estatedoes not affect the enjoyment ofincome during the transferor’s life-time, Section 2036(a)(2) will nottrigger gross estate inclusion.

Formula clause drawbacks. Trig-gering a certain amount of grossestate inclusion by formula is aningenious strategy. Nevertheless, ithas limitations. One limitation maybe simply that it is not well under-stood.30 Another is that, as the archi-tects of the strategy acknowledge,out of caution, the donor should notretain investment powers.31

Most importantly, the strategyis inflexible. Formula gross estateinclusion is not a true “toggling”technique, as gross estate inclusionor non-inclusion is automatic. Thatmakes a difference if it turns outthat the taxpayers do not value astep-up in basis in property asmuch as may have been assumedwhen the trust is created. Suppose,

for example, that after the father’sdeath, the family has no desire tosell ABC stock. The step-up inbasis, therefore, is not importantto them, as the ABC stock willnever be sold or otherwise disposedof. Nevertheless, the formula inclu-sion clause may cause an increasein estate taxes if it turns out thatestate tax savings from apprecia-tion do not outweigh the (hypo-thetical) capital gains tax saving.The family, however, would havepreferred the estate tax savings,even at the income tax cost, as itturns out that they are not inter-ested in sale.

In theory, if the timing of salecan be predicted with certainty, theformula inclusion amount can be modified with a present valuediscount factor and achieve theideal outcome.32 In many cases,however, it will not be possible topredict in advance when the recip-ients of property will actually wishto sell.33

Finally, formula inclusion claus-es have tax downsides. Like anyretained power causing gross estateinclusion immediately after thetransfer, a formula inclusion clauseprevents allocation of GST exemp-tion and, therefore, is not com-patible with GST tax planning.34

Further, as with retained powersdiscussed previously, to avoidpotential waste of the donor’sspouse’s gift and estate tax exclu-sion, the donor and the donor’sspouse should not elect to split giftsfor the year of the gift under Sec-tion 2513. The inability of spous-

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32 Id.33 Even the timing of estate tax payment may

not be possible to predict in advance. Forexample, the executor may obtain an exten-sion of time to pay estate tax under Section6161 or 6166. Although interest will becharged on deferred tax payments, the valueof deferral may still exceed the interest cost.If interest is charged under Section 6161, theinterest so charged will normally be deductiblefor estate tax purposes. These and other com-plications make it virtually impossible to getthe formula inclusion exactly right in advance.

34 Section 2642(f).

Retained powersshould not be used as a togglingstrategy if thedonor and thedonor’s spousewish to split gifts.

es to split gifts further limits theutility of formula inclusion.

Toggling inclusion on with conferred powersIn principle, gross estate inclu-sion can be toggled from off to on by having a power describedin Section 2038(a)(1) conferred onthe donor before the donor’s death.That section generally provides thatthe gross estate includes propertytransferred by the decedent duringlifetime, if the decedent couldchange the beneficial enjoyment ofthe property through a power toalter, amend, revoke, or terminate.Importantly, the section applies“without regard to when or fromwhat source the decedent acquired”the taxable power. Thus, a Sec-tion 2038(a)(1) power may triggergross estate inclusion, even if thedecedent did not reserve the powerat the time of the initial transfer.

Example. A father creates an irrev-ocable trust for his descendants, anddesignates another individual astrustee. The trustee, under the termsof the governing instrument, has thepower to terminate the trust at anytime and distribute all of the prin-cipal to the beneficiaries. Years later,

the trustee resigns and exercises apower under the governing instru-ment to appoint the father as the suc-cessor trustee. The father later diesholding the powers of the trustee,including to terminate the trust.

In an early case, White v. Poor,35the Supreme Court held that thepredecessor to Section 2038 did notcause gross estate inclusion in thiscircumstance. In the court’s view,the predecessor section did notapply if the power, although pos-sessed at death, was not retainedor reserved but was instead con-ferred on the decedent by another.The White v. Poor holding stilltechnically applies to transfersmade on or before 6/22/1936.36 Fortransfers made after that date, how-ever, Congress overturned White v.Poor by enacting what is now Sec-tion 2038(a)(1), which now may

cause gross estate inclusion regard-less of when or from what sourcethe decedent acquired the taxablepower.37 In the example, therefore,the father’s power at death to affectthe beneficial enjoyment of trustproperty is sufficient to cause grossestate inclusion, even though thefather did not retain the power atthe time of the initial transfer tothe trust.

Making use of Section 2038(a).Given the absence of a retentionrequirement, Section 2038(a)(1)could be used to cause gross estateinclusion of property that otherwisewould have passed free of estatetax.38 The following are three mech-anisms by which a donor could begiven a Section 2038(a) power at thetime of death that was not retainedat the time of transfer:

• Appointment of donor astrustee. First, as in the Whitev. Poor situation, a personother than the donor could begiven the power to appoint thedonor as a trustee (or co-trustee) with discretionary dis-tribution powers that are notlimited by an ascertainablestandard.39

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35 296 U.S. 98, 16 AFTR 977 (1935). 36 Section 2038(a)(2); Reg. 20.2038-1(c).37 See Rev. Rul. 70-348, 1970-2 CB 193 (hold-

ing that property of a Uniform Gifts to MinorsAct account is included in the donor’s grossestate if the donor was appointed custodianbefore his or her death).

38 As noted at the outset of this article, if prop-erty is pulled back into the gross estate underSection 2038(a) (or another section), the life-time taxable gift is effectively purged fromthe wealth transfer tax base under the estatetax computation procedures of Section 2001(b),so that the property is taxed only once. Sec-tion 2001(b)(2) also effective gives a credit forany gift taxes payable on the gift.

39 See also Rev. Rul. 70-348, supra note 37 (hold-ing that property of a Uniform Gifts to MinorsAct account is included in the donor’s grossestate if the donor was appointed custodianbefore his or her death). Section 2036(a)(2)should not apply, as that section applies onlywhere a power is reserved at the time of trans-fer. On the other hand, Section 2036(a)(2) doesapply if the transferor retained the power toappoint himself or herself as trustee on thedeath or resignation of the prior trustee. Rev.

Rul. 73-21, 1973-1 CB 405; Estate of Farrel,553 F.2d 637, 39 AFTR2d 77-1660 (Ct. Cl.,1977). Conceivably, although it does notappear that the IRS has made this argument,if a donor makes an irrevocable transfer butgives a third party a power to appoint the donoras trustee with discretionary distribution pow-ers, the donor could be viewed as retaining aSection 2036(a)(2) power, subject to a con-tingency (namely, another’s decision to appointthe donor as trustee). To avoid that argu-ment, it seems that the choice of a Section2038(a) trigger should be limited to a powerthat is exercisable only at the donor’s death.

40 Several cases have rejected the applicationof Section 2038(a) where the decedent com-pletely divested himself or herself of controlover the trust property, but later acquired pow-ers over the same property in an unrelatedtransaction. Estate of Reed, 36 AFTR2d 75-6413 (DC Fla., 1975); Estate of Skifter, 468F.2d 699, 30 AFTR2d 72-5920 (CA-2, 1972),nonacq. 1972-2 CB 4. Those cases shouldnot deny gross estate inclusion if a Section2038(a) power is conferred before deathunder one of the three mechanisms describedin the text, as Section 2038(a) does still applywhere the decedent “sets the machinery in

motion that purposefully allows” powers to bereturned to the donor.

41 Section 2036(a)(2) should not cause grossestate inclusion using the three techniquesdescribed in the text, as that section does notapply unless the donor retained (as opposedto merely possessed at death) the taxablepower. Cf. Reg. 20.2038-1(a) (“[I]t is imma-terial ... from what source the decedentacquires his power”) with Reg. 20.2036-1(requiring that a power be “retained orreserved” in order for Section 2036(a) toapply); see also White v. Poor, supra note35 (holding that the predecessor to Section2038(a)(2) did not apply to a power possessedat death if the power was not reserved at thetime of the transfer). In addition, if the powercan be exercised only at death, Section2036(a)(2) would not apply for an additionalreason, namely, that that section does notapply to powers that cannot affect the enjoy-ment of income during lifetime. Reg. 20.2036-1(b)(3).

42 Reg. 20.2038-1(b); Rev. Rul. 55-393, 1955-1 CB 448.

43 Reg. 20.2038-1(a); Helvering v. City BankFarmers Trust Co., 296 U.S. 85, 16 AFTR981 (1935); Rev. Rul. 70-513, 1970-2 CB 194.

Section 2038(a)(1)could be used tocause grossestate inclusion ofproperty thatotherwise wouldhave passed freeof estate tax.

• Third-party power of appoint-ment, exercisable in a mannerthat can give the donor a Section 2038(a) power. Second,a person other than the donorcould be given a special powerto appoint the property of the trust. This power couldthen be exercised in favor of atrust over which the donor has a power described in Section 2038(a), such as a special testamentary power ofappointment.

• Power to confer a testamen-tary power of appointment. Athird possibility is for an inde-pendent person, such an inde-pendent trustee, to be given apower to confer on the donora testamentary power ofappointment, which could beused to affect the beneficialenjoyment at death.

If the donor, by any of thesemechanisms, is given a Section2038(a) power by the time of hisor her death, the trust property canbe pulled back into his gross estate,should that be desirable.40

Suppose, on the other hand, thatthe donor dies without a Section2038(a) power actually having beenconferred. In principle, the trustproperty should escape gross estateinclusion.41 The reason is straight-forward: Even if a taxable powercould have been conferred on thedecedent, Section 2038(a) does notapply unless the power was pos-sessed at death.42 Thus, Section2038(a) does not cause gross estateinclusion if the donor does not pos-sess the power at the time of hisor her death. If the foregoing rea-soning is correct, then it is possi-ble to make gifts that will escapegross estate inclusion if a Section2038(a) power is not conferredbefore death, but will be pulledback into the donor’s gross estate(should that be desirable) if a Sec-

tion 2038(a) power is conferred. Inother words, it appears that it ispossible, using Section 2038(a), totoggle gross estate inclusion on.

That said, the strategy is notentirely free from risk. If it turnsout that gross estate inclusion isnot desirable, and a Section 2038(a)power is not conferred at the timeof the grantor’s death, the IRSmight still attempt to treat the dece-dent as possessing the power atdeath. The IRS might take the posi-tion that the power existed at deathon at least two grounds, as dis-cussed below. First, the IRS mightargue that the decedent held thepower in conjunction with anoth-er; second, the IRS might argue thatthe decedent held the power defacto. These possible challenges arediscussed below.

Powers held in conjunction withanother. Section 2038(a)(1) trig-gers gross estate inclusion regard-less of whether the decedent holdsa taxable power alone or in con-junction with others.

Example. A father transfers prop-erty in trust for the benefit of hisdaughter, but retains the power,with the daughter’s consent, torevoke the trust at any time. Despitethe fact that the father may notrevoke the trust without the con-sent of his daughter, his power torevoke will cause the trust prop-erty to be included in his grossestate at death. That the daughterhas an interest in vetoing revoca-tion does not matter: A power isconsidered exercisable in conjunc-tion with another person regard-less of whether that other personhas an interest adverse to the exer-cise of the power.43

The principle that a decedent isconsidered to possess a power atdeath under Section 2038(a)(1),even if the power is exercisable inconjunction with another, could

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frustrate the use of a conferrablepower to achieve gross estate inclu-sion toggling.

Example. A father makes a gift of$5 million worth of XYZ Corpshares to an irrevocable trust forhis descendants. Although thefather does not retain any powersthat trigger gross estate inclusion,the terms of the trust permit thetrustee to resign and appoint thefather as successor trustee, just incase the value of the shares declinesand gross estate inclusion becomesdesirable. In this manner, it ishoped, the father can have theshares pulled back into his grossestate, should they decline in value,by asking the trustee to appoint himas co-trustee.

Suppose, however, that theshares of XYZ Corp do not declinebut quadruple in value. The fathernow wants to be sure that the shareswill not be included in his grossestate. It may seem that, unless thefather is actually appointed as a co-trustee, he will not be consideredto possess a Section 2038(a) powerat death. But the IRS could, per-haps, see it differently. After all, theonly thing standing in the way ofthe father having the power toaffect the beneficial enjoyment ofthe trust property is the trustee

resigning and appointing the fatheras successor trustee.

If the trustee actually does resignand appoint the father as succes-sor, then the father would clearlypossess a Section 2038(a)(1) power.But even if the father is not formallyappointed, the IRS could argue thathe effectively already has the power,in conjunction with the initialtrustee, to affect beneficial enjoy-ment of trust property. That is, withthe cooperation of the trustee, thefather can arrange to be appoint-ed as trustee and thereby affect thebeneficial enjoyment of the trustproperty. In short, the IRS couldargue that the father has a Section2038(a)(1) power merely by virtueof the trustee’s ability to appointthe father as trustee.

The IRS’s possible appeal to theconjunction principle conflicts withanother, equally well-establishedprinciple of Section 2038(a): name-ly, that that the section does notcause gross estate inclusion if thedecedent’s power to affect benefi-cial enjoyment was subject to a con-tingency beyond the donor’s con-trol.44 For example, if a fathertransfers property irrevocably intrust, and appoints himself as suc-cessor trustee (with distributionpowers) after the death of the ini-tial trustee, Section 2038(a) will

not cause gross estate inclusion ifthe father predeceases the initialtrustee.45 By the same token, if thedonor cannot acquire a Section2038(a) power unless the poweris conferred on the donor by anoth-er, it seems that gross estate inclu-sion will not be triggered unless thepower is actually conferred.

Indeed, it appears that a long-standing ruling, Rev. 55-393,46 com-pels the IRS to view another per-son’s ability to confer a taxablepower on the donor as a contingencythat defeats application of Section2038(a)(1).47 That ruling consideredtwo situations. In the first, the donorretained the right to remove thetrustee and appoint the donor assuccessor trustee; in the second, thedonor could appoint himself astrustee only if the initial trusteeresigned or was disqualified to act.The IRS ruled that Section 2038(a)caused gross estate inclusion onlyin the first situation but not in thesecond, unless at the time of thedonor’s death the initial trustee’s res-ignation or disqualification hadactually occurred. Importantly, inthe second situation, the IRS did notview the donor as having possesseda Section 2038(a) power in con-junction with the trustee. On thecontrary, the IRS viewed the possi-ble resignation of the initial trustee

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44 Reg. 20.2038-1(b). 45 Id.46 Note 42, supra. 47 Revenue rulings are generally binding on the

Treasury Department. Rauenhorst, 119 TC157 (2002) (treating a revenue ruling as a con-cession by Commissioner); Van Alen, TCM2013-235.

48 Although Tully did not cite the case, Byrum,408 U.S. 125, 30 AFTR2d 72-5811 (1972), fur-ther supports the holding of Tully. In Byrum,a case decided under Section 2036(a)(2), thecourt rejected the IRS argument that the dece-dent, through a retained power to vote sharesof stock transferred to an irrevocable trust,retained a “right” to determine the individualswho shall enjoy the income from the stock. Theterm “right,” Byrum reasoned, must be con-strued to mean a legally enforceable power.A decedent who had to ask another person toconfer a Section 2038(a) power does not havea legally enforceable power under the Byrumcourt’s construction.

49 Cf. Byrum, supra note 48 (“The term ‘right’... connotes an ascertainable and legallyenforceable power”).

50 In Rev. Rul. 70-348, 1970-2 CB 193, the dece-dent transferred shares to a custodian forhis children under the Uniform Gifts to MinorsAct. Although the decedent was not initial-ly appointed as custodian, the decedent wasappointed as successor custodian by thetime of his death after the initial custodianresigned. The IRS ruled that because thedecedent was the transferor “and died hold-ing these shares as successor custodian forsuch minor children,” the shares were includ-ed in the decedent’s gross estate under Sec-tion 2038(a)(1). The basis of the ruling’s hold-ing, in other words, was that the decedentactually held the powers of a custodian atdeath. The mere fact that the decedent couldhave been appointed as custodian wouldnot appear to have been sufficient to causegross estate inclusion, without an actualappointment.

51 Cf. Byrum, supra note 48 (“The term ‘right’... connotes an ascertainable and legallyenforceable power”).

52 1995-2 CB 191. 53 Estate of Wall, 101 TC 300 (1993); see

also Estate of Vak, 973 F.2d 1409, 70 AFTR2d 92-6239 (CA-8, 1992), rev’g TCM1991-503.

54 Rev. Rul. 79-353, 1979-2 CB 325. 55 Unfortunately, the ruling’s holding refers only

to discretionary powers over income, butnot principal. It seems, however, that therationale for the ruling, which was to createa safe harbor in light of IRS losses in Estateof Wall, supra note 53, and other cases, wouldapply with equal force to discretionary pow-ers over principal.

56 Section 672(c), an income tax section, definesthe term “related or subordinate party” forpurposes of Subpart E of Part I of Subchap-ter J of chapter 1 of the Code.

57 Note 53, supra.

as a “contingency” the nonoccur-rence of which prevented Section2038(a) from applying.

Even if not foreclosed by Rev. Rul.55-393, any IRS argument that thedecedent effectively possessed a Sec-tion 2038(a) power at death by virtueof another person’s ability to confersuch a taxable power would still belikely to fail. The reason is that Sec-tion 2038(a) applies to enforceablepowers but not to mere powers ofpersuasion. In the foundational caseof Estate of Tully, for example, thedecedent owned half the shares ofa corporation that had an agreementwith the two shareholders, includ-ing the decedent, to pay a death ben-efit to the widow of a deceased share-holder. The IRS argued that thedecedent held a Section 2038(a)(1)power at the time of his death byvirtue of his ability, in conjunctionwith the other shareholder, to mod-ify the death benefit. Rejecting thatargument, the court in Tully heldinstead that the decedent did not pos-sess a “power” within the meaningof Section 2038(a).48

The court began by noting thatthe decedent did not expresslyreserve the right to change the deathbenefit under any agreement underwhich the death benefit was creat-ed. Given the absence of an expressreservation, reasoned the court, allthat the decedent possessed at deathwas the possibility of persuading hisfellow shareholder to modify theagreement and change the deathbenefit. But the term “power,” thecourt held, “does not extend to pow-ers of persuasion” or to mere “spec-ulative powers.”49 The decedent’sability to coax his co-shareholderinto changing the death benefit didnot, Tully holds, rise to the level ofa taxable power.50

Where a donor gives anotherperson the right to confer a Section2038(a) power on the donor, andthe power is not actually conferred,then the donor dies without a legal-

ly enforceable power to compel thatother person to confer the taxablepower.51 The donor can, of course,attempt to remonstrate with theother person and ask that the tax-able power be conferred. UnderTully, however, a mere power ofpersuasion is not a taxable powerwithin the meaning of Section2038(a). It seems, therefore, thatwhere a donor gives another per-son the right to confer a Section2038(a) power on the donor, butthe power is not actually conferred,the donor will not be deemed tohold a taxable power at death.

De facto power. A second argumentthat the IRS could make in orderto frustrate the use of Section2038(a) to toggle on gross estateinclusion is that, even if an enforce-able Section 2038(a) power is notactually conferred on the grantor,the grantor should in substance stillbe deemed to possess such a powerat death.

Example. Suppose, once again, thatthe father makes a gift of $5 mil-lion worth of XYZ Corp shares toan irrevocable trust for his descen-dants, and the terms of the trustpermit the trustee to resign andappoint the father as successortrustee. Suppose, further, that thetrustee, a close friend and businessassociate of the father, would, asa practical matter, always resignand appoint the father as succes-sor trustee at the father’s request.As things turn out, the XYZ Corpshares increase in value by the time

of the father’s death, and the trusteenever resigns or appoints the fatheras trustee. Nevertheless, at thefather’s death, the IRS argues thatthe shares should be included in thefather’s gross estate, on the theo-ry that the trustee, as a practicalmatter, would have resigned andappointed the father as successorat the father’s request. Therefore,the IRS argues, the trustee’s pow-ers should be imputed to the fatherfor tax purposes.

At first, it might seem that theIRS’s de facto powers theory haslittle chance of success. In Rev. Rul. 95-58,52 the IRS, after a seriesof court losses,53 revoked prior rul-ings54 that had held that a dece-dent’s retained power to removeand replace a corporate trustee wasequivalent to the decedent holdingthe trustee’s discretionary distri-bution powers. Rev. Rul. 95-58holds instead that a trustee’s dis-cretionary power over income55 willnot be imputed to the decedent,even if the decedent retained apower to remove and replace thetrustee, so long as the decedentcould not appoint a replacementtrustee who was not related or sub-ordinate to the decedent within themeaning of Section 672(c).56

In the foregoing hypothetical,the father retains no power even toremove the trustee. Instead, all hecan do is ask the trustee to resignand appoint him as successortrustee. But even an enforceablepower to remove and replace thetrustee will not, under Rev. Rul.95-58, cause the trustee’s powersto be imputed to the grantor. A fortiori, it seems, a mere power torequest that the trustee resignwould not cause the trustee’s pow-ers to be imputed to the grantor.

Court decisions. The Tax Court’sopinion in Estate of Wall 57 likewisemakes it unlikely that the IRSwould successfully be able to

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It seems, a merepower to requestthat the trusteeresign would not cause thetrustee’s powersto be imputed to the grantor.

impute a trustee’s powers to thedecedent. In Wall, the decedentretained the power to remove andreplace the corporate trustee of dis-cretionary trusts that she had cre-ated for her daughter and grand-daughters. The IRS, advancing aposition that Rev. Rul. 95-58 laterdisavowed,58 argued that retainingthe power to remove and replace thecorporate trustee was equivalent toretaining the trustee’s powers direct-ly. The Tax Court held on the con-trary that Sections 2036(a)(2) and2038(a) apply only where the dece-dent held an “ascertainable andlegally enforceable power,” as theSupreme Court put it in Byrum.59

A decedent does not retain alegally enforceable power of anykind, not even to replace thetrustee, where the decedent’s acqui-sition of a Section 2038(a) powerdepends entirely on the actions ofanother. Under Wall, therefore, itseems unlikely the IRS could suc-cessfully impute a taxable powerto the decedent merely because sucha power could be conferred on thedecedent by a third party.

That said, the de facto powerstheory may be not as moribund asit might otherwise appear, in lightof Rev. Rul. 95-58 and Estate ofWall.60 For one thing, even in Wall,the court stated that the IRS hadfailed to provide any compelling rea-son to infer a “fraudulent side agree-

ment” between the donor and thetrustee. The court did not specify,exactly, how the existence of suchan agreement might have affectedthe outcome. After all, given thecourt’s holding that a “legallyenforceable power” is required forSection 2038 to apply, the existenceor nonexistence of a legally unen-forceable side understanding oragreement would seem to be irrel-evant. Nevertheless, the negativeinference of the court’s comment isthat evidence of an agreement orunderstanding as to the potentialgranting of a legally enforceablepower may be sufficient to imputethe power to the grantor.

Second, Estate of Beckwith,61

apparently remains good law. InBeckwith, the court held that thedecedent had not retained a rightdescribed in Section 2036(a)(2).(Beckwith did not address Section2038(a); nevertheless, given theextensive overlap of the two sec-tions, Beckwith’s reasoning wouldapparently apply with equal forceto Section 2038(a).62) In so hold-ing, however, the court took forgranted that the application of Sec-tion 2036(a)(2) does not “depend[]upon the express reservation of alegally enforceable right,” butrather may apply based on a “pre-arrangement, or at least an infor-mal agreement or understanding,under which the right is retained.”

Beckwith declined to find that suchan agreement existed under thefacts of the case. Had such an agree-ment or understanding been foundto exist, however, then section2036(a)(2) would, under the prin-ciples adopted by Beckwith, havecaused gross estate inclusion.

Finally, recent cases have, per-haps, breathed new life into the defacto powers theory. In S.E.C. v.Wyly,63 for example, the court heldthat the grantors of off-shore trusts,even though they did not retain anyformal powers over trust decisions,nevertheless, for tax purposes, held the de facto power to veto dis-cretionary distribution powersdescribed in Section 674(a). TheWyly court rejected prior cases64

that had held, following Byrum, thata legally enforceable right is re-quired in order for a grantor to beconsidered to have the power to par-ticipate in or veto distribution decisions.

Similarly, in Webber,65 the courtheld that the taxpayer, even thoughhe had no legal right to chooseinvestments made through a trust-owned private placement life insur-ance policy, nevertheless effective-ly controlled the investmentdecisions in substance. Neither Wylynor Webber involved Section2038(a), or estate and gift tax pro-visions more generally. Neverthe-less, they demonstrate that courts

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58 Note 54, supra. 59 Note 48, supra. 60 Reg. 20.2038-1(c) provides that, in the case

of a transfer made before 6/23/1936, a powerwill be considered retained or reserved if therean “understanding, express or implied” thata power would later be created or conferred.To date, it does not appear that the IRS hassought to import the notion of an “impliedunderstanding” to powers over property trans-ferred on or after 6/23/1936. If that notion wereso incorporated, then perhaps a grantor couldbe considered to hold a taxable Section2038(a) power de facto, whether or not thealleged power is legally unenforceable.

61 55 TC 242 (1970). 62 See, e.g., Estate of Wall, supra note 53. 63 56 F.Supp.3d 394 (DC N.Y., 2014). 64 Goodwyn, TCM 1976-238. 65 144 TC 324 (2015).

66 For further discussion of the significance ofWyly and Webber in estate planning, see Kee-nen and Zeydel, “Is Designating an Inde-pendent Trustee a Tax Panacea?,” 43 ETPL3 (February 2016).

67 Reg. 20.2038-1(b). 68 The “ETIP” rule of Section 2642(f) should

not apply, as the rule applies only if the trans-ferred property would be included in thegrantor’s gross estate immediately after thetransfer. If a section 2038 power is ultimate-ly conferred and the transferred property ispulled back into the gross estate, no addi-tional allocation of GST exemption would berequired to achieve a zero inclusion ratio. Reg.26.2642-4(a)(3) (“If the value of property heldin a trust created by the transferor, withrespect to which an allocation was made ata time that the trust was not subject to an ETIP,is included in the transferor’s gross estate,the applicable fraction is redetermined if addi-

tional GST exemption is allocated to the prop-erty.... If additional GST exemption is not allo-cated to the trust, then, except as providedin this paragraph (a)(3), the applicable frac-tion immediately before death is not changed,if the trust was not subject to an ETIP at thetime GST exemption was allocated to thetrust.”) Of course, if property has declinedin value, GST exemption will have gone towaste, but that is the same result that obtainsregardless of whether property is pulled backinto the gross estate.

69 Actually, if gross estate inclusion is toggledon by having a Section 2038(a) power con-ferred on the grantor, it may still be possi-ble, as discussed earlier in the text, to pre-vent gross estate inclusion, even if the grantordies within three years, if a third party effec-tively expunges the grantor’s Section 2038(a)taxable powers before death.

may still be willing to hold that anindividual controls trustee decisionsin substance, even if the individual’scontrol is not legally enforceable.66

That said, careful drafting andadministration can mitigate the riskthat the decedent will be deemedto hold a Section 2038(a) power atdeath, even if the power is not actu-ally conferred. First, the governinginstrument could provide that aSection 2038(a) taxable power canbe conferred only if certain condi-tions, beyond the control of thegrantor or any other person, aremet. For example, the instrumentcan permit the power to be con-ferred only if the estate tax savings(if any) from avoiding gross estateinclusion exceed the income taxsavings. As Section 2038(a) doesnot apply to powers subject to acontingency beyond the decedent’scontrol,67 the condition should pre-vent gross estate inclusion if thatis the desired outcome, even if itis true that the decedent may bedeemed to have de facto controlover the person who would havehad the right to confer a Section2038(a) power on the decedent.

Second, the trust instrumentcould be drafted to avoid theappearance of any understandingthat the grantor would be given aSection 2038(a) power. For exam-ple, one way to cause a Section2038(a) power to be conferred onthe donor before death is to givethe trustee a power to appoint thegrantor as trustee. In drafting sucha power, specific references to thegrantor could be avoided. Instead,the trustee could be given the powerto appoint any individual (implic-itly including the grantor) or bankor trust company. Of course, stan-dard savings language that wouldnormally prevent the grantor fromever acquiring a Section 2038(a)power should not be included.

Finally, the donor—or, better yet,a third person—could be given

the power to void in advance anyfuture attempt to confer a taxablepower on the donor. For example,if the trust instrument permits thedonor to be appointed as successortrustee, but the donor determinesthat gross estate inclusion is notdesirable, the donor could renouncethe ability to be appointed as suc-cessor trustee. To avoid the three-year rule of Section 2035(a), aneven better solution would be fora third party to be given the powerto remove the donor from the classof persons who may validly beappointed as successor trustee. Ifthat third party does prohibit theappointment of the donor astrustee, then it would seem very dif-ficult for the IRS to impute thetrustee’s powers to the donor mere-ly because, at one time, it was pos-sible for the donor to have beenappointed as successor trustee.

Other a spects of using Section2038(a) to toggle gross estate inclu-sion on. Besides the estate andincome tax advantages of preserv-ing toggling flexibility, using Sec-tion 2038(a) to trigger gross estateinclusion is attractive for GST taxplanning purposes, as the ability toconfer a Section 2038(a) powershould not prevent GST exemptionfrom being allocated from the timeof the initial gift.68 As with retainedor automatically triggered powersdiscussed above, if the donor andhis or her spouse elect to split giftsfor the year of the gift, there is adanger that the spouse’s gift taxexclusion amount will be wasted ifthe trust property is later pulledback into the gross estate. A gift-splitting election, therefore, shouldbe made with caution.

Toggling inclusion off and on again with QTIP trustsThus far, this article has consideredstrategies that permit gross estateinclusion to be toggled from on to

off (such as if the grantor retainsa gross estate inclusion string whichis expunged before the grantor’sdeath) or from off to on (such asif the trust instrument permits aSection 2038(a) power to be con-ferred on the grantor). Only oneturn of the switch is apparently per-mitted.69 Even better, however,would be to switch gross estateinclusion on or off once, and thenretain the ability to reverse thatdecision if circumstances change.

As discussed below, it seems that,for married couples, a second tog-gling is permitted with proper plan-ning. Specifically, through the useof a QTIP trust, a surviving spousemay turn off gross estate inclusion,yet have it turned back on at a latertime, should that be desirable.

Example of QTIP toggl ing planning. To understand how tog-gling works with a QTIP trust, suppose that the first spouse to dieor “first decedent” leaves all of hisor her assets for the benefit of thesurviving spouse in the form of aqualified terminable interest prop-erty (QTIP) trust. The survivingspouse, as required for the QTIPtrust to qualify for the estate taxmarital deduction, is entitled to allincome. In addition, principal maybe distributed to the survivingspouse in the discretion of an inde-pendent trustee.

The QTIP trust also has twounconventional provisions. First,the surviving spouse is authorizedto assign the right to the income

13


Through the use of a QTIPtrust, a survivingspouse may turnoff gross estateinclusion, yet haveit turned back on at a later time.

from the trust to or for the benefitof the couple’s descendants. Oth-erwise, however, the income inter-est is unassignable and enjoysspendthrift protection. Second, theindependent trustee is authorizedto confer on the surviving spousea special testamentary power toappoint the property of the QTIPtrust at the surviving spouse’sdeath. These two provisions maybe known as the QTIP trust’s “tog-gling provisions.”

Finally, after the first decedent’sdeath, his or her executors elect toqualify the QTIP trust for the mar-ital deduction. They also make aportability election under Section2010 to cause the first decedent’sexclusion amount to be treated asthe surviving spouse’s own. In sum-mary, all of the first decedent’s estatequalifies for the marital deductionthrough a QTIP trust with togglingprovisions, and the surviving spouseinherits the first decedent’s unusedestate tax exclusion amount.

Default outcome of QTIP togglingplanning. Thanks to the QTIP elec-tion by the first decedent’s execu-tors, if the surviving spouse doesnothing else, the QTIP principalwill be included in the survivingspouse’s gross estate under Section2044. That section generally caus-es QTIP property to be included inthe beneficiary spouse’s gross estateat death. In addition, the proper-ty will qualify for a step-up in basisunder Section 1014(b)(10). Thedefault outcome, in other words,is that the QTIP property will besubject to estate tax and will alsoqualify for a step-up in basis.

In many cases, gross estate inclu-sion under Section 2044 will be theoptimal result. Suppose, for exam-ple, that the first decedent, havingmade no lifetime taxable gifts, dieswith $4 million, which he leaves tothe surviving spouse in the form aQTIP trust with “toggling” provi-

14


70 The value of the gift is likely to be small, giventhat the right to income could be defeated atany time if principal is distributed to the sur-viving spouse. Rev. Rul. 75-550, 1975-2 CB357 (valuing an income interest at a discountto reflect all possible invasions of principal);see also Rev. Rul. 67-370, 1967-2 CB 324.

71 Regs. 25.2505-2(b) and 20.2010-3(b)(2),Example.

72 The fact that the wife may continue to be thediscretionary beneficiary of principal doesnot prevent a completed gift from occurring.Ltr. Rul. 201243004; see also Reg. 25.2519-1(g), Example 5 (stating that the valuationrules of Section 2702, which apply only tocompleted gifts, apply to the deemed trans-fer under Section 2519, even though thespouse continued to be a discretionary ben-eficiary of principal); Herzog, 116 F.2d 591,26 AFTR 169 (CA-2, 1941); Ltr. Rul.200944002. However, the transfer will, it

seems (although there is no direct authorityon point), be deemed to be incomplete if thebeneficiary of a QTIP trust has a testamen-tary power of appointment.

73 1995-2 CB 191. 74 Uhl, 241 F.2d 867, 50 AFTR 1746 (CA-7, 1957);

German, 7 Ct. Cl. 341, 55 AFTR2d 85-1577(1985); Rev. Rul. 76-103, 1976-1 CB 293; Rev.Rul. 2004-64, 2004-2 CB 7; Ltr. Rul.200944002.

75 Rev. Rul. 76-103, supra note 74; Ltr. Rul.200944002.

76 Reg. 20.2036-1(c)(1)(i); see also Rev. Rul.2004-64, supra note 74; Ltr. Rul. 200944002.

77 Linderme, supra note 23; Guynn, 437 F.2d1148, 27 AFTR2d 71-1653 (CA-4, 1971);Estate of Maxwell, 3 F.3d 591, 72 AFTR2d 93-6733 (CA-2, 1993); Reichardt, 114 TC 144(2000); Estate of Kerdolff, 57 TC 643 (1972);Paxton, supra note 23.

sions, and the surviving spouseholds $4 million of assets of herown. Even if the $4 million in theQTIP trust appreciates to $6 mil-lion by the time of the survivingspouse’s death, the survivingspouse’s estate exclusion amount,including the unused exclusion thatshe inherits from the first decedent,will still be sufficient to shield herentire gross estate, including theQTIP trust, from estate tax. Mean-while, the QTIP trust assets willqualify for a step-up in basis, there-by eliminating capital gains tax onpre-mortem gains, without estatetax cost. In this case, gross estateinclusion is the optimal outcome,as it produces no estate taxes, butsaves capital gains tax on the saleof QTIP property after the surviv-ing spouse’s death.

Toggling QTIP gross estate inclu-sion off. But suppose instead thatthe QTIP trust, prior to the sur-viving spouse’s own death, willappreciate to such an extent thatthe surviving spouse’s applicableexclusion amount (including inher-ited exclusion) will likely not coverthe full value of the QTIP trustwhen he or she dies. In that case,he or she might prefer to causefuture appreciation in the QTIPtrust assets to escape estate tax. The“toggling” provisions of the QTIP

trust permit the surviving spouseto do just that.

Specifically, the surviving spousecan assign his or her right to theincome from the QTIP trust to orfor the benefit of the couple’s descen-dants. If this is done, the survivingspouse will have made a taxable giftequal to the value of the right to theincome from the QTIP trust.70 Inaddition, under Section 2519, thesurviving spouse will be deemed, forgift and estate tax purposes, to havemade a gift of all interests in theQTIP trust other than the right toincome. That is to say, the surviv-ing spouse will be deemed to havemade a gift of principal.

The gifts combined—i.e., the giftof the right to income, and thedeemed gift of principal—will beequal to the value of the entireQTIP trust at the time of the assign-ment. No gift tax will be due, how-ever, as the surviving spouse’s appli-cable exclusion amount underSection 2505, including the exclu-sion amount inherited from the firstdecedent, will be large enough toabsorb the gross gift tax comput-ed on the gift. (Indeed, under theportability regulations, the firstdecedent’s exclusion is deemed tobe used up prior to the survivingspouse’s own “basic” exclusionamount.71) Thus, the effect of thegift will be similar to the first dece-

dent having used up his or her ownexclusion at his or her death.

Meanwhile, although the sur-viving spouse has made an irrevo-cable gift of income, he or she doesnot lose access to the principal ofthe trust.72 On the contrary, he orshe continues to be eligible for dis-tributions of principal in the dis-cretion of the trustee. Should thesurviving spouse need distributionsfor his or her own needs, the inde-pendent trustee can simply makeprincipal distributions to the sur-viving spouse. The surviving spousecan even have the right, under theterms of the trust created by thefirst decedent, to remove andreplace trustees, within the limitsprescribed by Rev. Rul. 95-58.73

Although the surviving spouseis the deemed transferor of theQTIP trust under Section 2519, andhe or she continues to be the ben-eficiary of the principal, the QTIPtrust property should neverthe-less (if no other planning steps aretaken) pass outside of the surviv-ing spouse’s estate for estate taxpurposes. Normally, as noted, QTIPtrust property is included in thebeneficiary spouse’s gross estateunder Section 2044. That sectiondoes not apply, however, to prop-erty that was deemed to have beentransferred under Section 2519.Thus, Section 2044 does not causegross estate inclusion at the sur-viving spouse’s death.

To be sure, the surviving spouseis deemed to be the transferor ofthe QTIP property for estate taxpurposes. Thus, if the survivingspouse is deemed to have retained(or, in the case of Section 2038, tohave possessed at his or her death)any of the rights or powersdescribed in Sections 2036 or 2038,the trust principal could be includ-ed in the surviving spouse’s grossestate at death. With proper plan-ning, however, it should be possi-ble to avoid that result, if desired.

To begin, it is well-establishedthat a decedent’s mere eligibility toreceive distributions from an inde-pendent trustee, and nothing more,does not cause property transferredduring lifetime to be included in the gross estate under Section2036(a)(1) or 2038.74 If the trans-ferred property was subject toclaims of the decedent’s creditors,then the decedent is considered tohave retained powers over thetransferred property described inSections 2036(a) and 2038.75 But atransfer under Section 2519 is adeemed transfer purely for tax pur-poses; it is not a transfer at all forstate law purposes, or a transfer intrust that might otherwise be voidas against creditors. On the con-trary, after a beneficiary of a QTIPtrust assigns the right to income butretains a discretionary interest inprincipal, the spouse who createdthe trust remains the settlor of thetrust for state law purposes.

In other words, for tax purposes,although the surviving spouse isdeemed to have transferred princi-pal for his or her own benefit, thetrust is not a self-settled trust forstate law purposes and, therefore,cannot be void as against the cred-itors of the beneficiary spouse. Con-sequently, the beneficiary spousemay trigger a deemed transfer ofprincipal under Section 2519, con-tinue to hold a discretionary inter-est in principal, and have the prin-cipal protected against claims of thebeneficiary’s creditors under stan-dard spendthrift provisions. Cred-itors’ rights doctrine, therefore, doesnot cause the principal of the trustto be included in the spouse’s grossestate under Section 2036(a)(1).

Section 2036(a)(1) can alsoapply where there was an agree-ment, express or implied, that thedecedent would retain the right toincome or the beneficial enjoymentfrom the transferred property.76

Thus, courts have found an implied

understanding to exist and pulledtransferred property back into adecedent’s gross estate at death,where the decedent, although he orshe did not retain any legal right tothe property, was in actual pos-session of, or was actually enjoy-ing, the transferred property.77 Fora number of reasons, however, itseems that, in the case of a deemedtransfer under Section 2519, itwould be difficult for the IRS toestablish that there was an impliedunderstanding that the trusteewould thereafter make discre-tionary principal distributions.

For one thing, the transfer ofprincipal under Section 2519 ispurely notional. There is no actu-al transfer of property with respectto which an understanding, expressor implied, regarding distributionscould even arise. Indeed, the spousemay trigger a deemed transferunder Section 2519 without evencommunicating with the trustee.The deemed transfer could evenoccur at a time when no trusteeauthorized to make principal dis-tributions is even serving. Thus,with proper planning, the risk ofgross estate inclusion under Sec-tion 2036(a)(1), following adeemed transfer under Section2519, seems to be minimal. Possi-bly, the spouse could receive evenliberal distributions of principalwithout causing the QTIP trustproperty to be included in thespouse’s gross estate at death.

In short, by incorporating tog-gling provisions, the couple canmake it possible for the survivingspouse to be deemed to have madea taxable gift of QTIP property that,similar to the credit shelter trust,uses up the first decedent’s exclu-sion. Just as with a credit sheltertrust, the QTIP property, includingappreciation after the date of thegift, should pass outside of the sur-viving spouse’s gross estate at death.Meanwhile, the surviving spouse

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continues to be eligible to receivedistributions of principal. The QTIPtrust, after the deemed transfer underSection 2519 occurs, essentially func-tions like a credit shelter trust.

Toggling gross estate inclusionback on. Now suppose that, hav-ing triggered Section 2519 in orderto cause QTIP trust property topass outside of his or her grossestate, the surviving spouse decidesthat the trust property should bepulled back into his or her grossestate after all. For example, it maybe that the combined value of theQTIP trust plus the survivingspouse’s other assets is less than thesurviving spouse’s applicable exclu-sion amount (including the exclu-sion amount inherited from the firstdecedent). In that case, the sur-viving spouse’s family may be bet-ter off obtaining a step-up in basisunder Section 1014(a). Anotherpossible reason for preferring grossestate inclusion may be that, fol-lowing the deemed gift under Sec-tion 2519, the value of the QTIPtrust principal has declined in value.In that situation, it would be prefer-able, as discussed at the outset ofthis article, for the deemed gift tobe purged from the estate tax baseand for trust principal to be includ-ed in the surviving spouse’s grossestate at its reduced value.78

Thanks to the toggling provisionsof the QTIP trust, it should be pos-sible to turn gross estate inclusionback on. Specifically, the inde-pendent trustee can exercise a powerto confer on the surviving spouse aspecial testamentary power ofappointment. Such a power, onceconferred, will cause the QTIP prop-erty to be pulled back into the sur-viving spouse’s gross estate underSection 2038(a), as the survivingspouse is the deemed transferor ofprincipal for estate tax purposesunder Section 2519. As a result, theQTIP trust principal should be

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78 It would seem that only the deemed gift ofprincipal is purged from the estate tax baseunder Section 2001(b), but not the gift ofincome. The value of the gift of an incomeinterest, however, may be discounted toreflect its possible divestment or curtailment,by virtue of the trustee’s power to pay out principal. Cf. Rev. Rul. 75-550, supranote 70 (valuing an income interest at adiscount to reflect all possible invasions ofprincipal); see also Rev. Rul. 67-370, 1967-2 CB 324.

79 There is some uncertainty as to whether adeemed transfer under Section 2519, followedby gross estate inclusion under one of the“string” sections of the Code, will success-fully cause the property included in the grossestate to qualify for a change in basis underSection 1014(b)(9). For further discussion ofthis issue, see Bramwell and Socash, “Pre-serving Inherited Exemption: The New Plan-ning Frontier,” Real Property, 50 Trust andEstate Law J. 1 (Spring 2015).

80 Note 40, supra.

81 See also Estate of Skifter, 468 F.2d 699, 30AFTR2d 72-5920 (CA-2, 1972); Rev. Rul. 84-179, 1984-2 CB 195.

82 Reg. 25.2519-2(g), Example 4. 83 Reg. 26.2652-1(a)(3). 84 For further discussion of this complex issue, see

Bramwell and Weissbart, “The Dueling Trans-ferors Problem in Generation-Skipping Trans-fer Taxation,” 41 ACTEC L. J. 95 (2016). Evenif the surviving spouse is considered the trans-feror of the income for GST tax purposes, onlya minimal amount of GST exemption would needto be allocated in order to protect the incomeinterest from GST tax, as the value the surviv-ing spouse’s gift of income should be de min-imis. Rev. Rul. 75-550, supra note 70.

85 See generally Blattmachr, Bramwell, and Zey-del, “Portability or No: The Death of the Cred-it-Shelter Trust?,” 118 J. Tax’n 232 (May 2013).

86 See Zeydel, “Portability or No: Death of theCredit Shelter Trust?,” 49 33 U. of MiamiLaw Center’s Philip E. Heckerling Institute onEstate Planning 303 (2015).

included in the surviving spouse’sgross estate, the deemed Section2519 gift should be eliminated fromthe transfer tax base under Section2001(b), and the QTIP trust prin-cipal should qualify for a changein basis under Section 1014.79

Unique advantages of QTIP toggling. As discussed previously,there is some risk, with Section2038 toggling planning, that thegrantor will be deemed to hold Sec-tion 2038 powers de facto, in whichcase, gross estate inclusion wouldnot be possible to avoid. But witha deemed Section 2519 transfer, therisk of the surviving spouse beingtreated as holding the trustee’s powers is minimal, and perhapseven nonexistent. The reason, onceagain, is that a deemed Section2519 transfer is purely notional.As noted above, the survivingspouse could trigger Section 2519,conceivably, without any priorcommunication with the inde-pendent trustee. Thus, there is lit-tle chance that the IRS would beable to infer some kind of pre-arrangement or informal under-standing between the survivingspouse and the independent trustee.

Indeed, if anything, the oppositeproblem arises, namely, that the

IRS will not respect the conferredspecial power of appointment asa valid gross estate inclusion trig-ger under Section 2038(a). As sup-port for denying gross estate inclu-sion, the IRS could look to thedecisions in cases holding that Sec-tion 2038 does not apply if thegrantor made a complete disposi-tion of his or her interest in prop-erty, and an otherwise taxablepower later returned to the grantorin an unrelated transfer. In Estateof Reed,80 for example, the dece-dent had made a gift of shares tohis daughter through a UniformGifts to Minors Act account; afterthe custodianship terminated, thedaughter then reconveyed the prop-erty to the decedent as trustee forher benefit. The court held that Sec-tion 2038 did not apply, becausethe decedent made a complete dis-position of property and the dece-dent happened to possess controlover the property at death only “bya totally unrelated and fortuitousconveyance.”81

Conceivably, on the strength ofReed and related cases, the IRS couldargue that the independent trustee’sdecision to confer a special powerof appointment on the survivingspouse is an “unrelated and fortu-itous conveyance” that does not

cause Section 2038 to apply, and sogross estate inclusion is not suc-cessfully toggled on. After all, theindependent trustee’s ability to con-fer a special power of appointmenton the surviving spouse was not cre-ated by the surviving spouse herselfbut existed under the terms of a trustcreated by the first decedent. In thisview, although the surviving spouseis deemed to be the transferor of thetrust property for estate tax pur-poses under Section 2519, that isnot enough for him or her to haveset in motion the machinery thatlater caused the surviving spouse tohave a special power of appointmentat death.

As yet, it is unclear whether thisargument will prevail. That said, itdoes seem to be contrary to thelogic and intent of Section 2519.Following a disposition of a qual-ifying income interest for life in aQTIP trust, that section deems thespouse beneficiary to have made atransfer for all estate and gift taxpurposes. Thus, if the survivingspouse retains the right to a por-tion of the income from the trustproperty, the property will beincluded in his or her gross estateunder Section 2036(a)(1).82 By thesame logic, with QTIP toggling pro-visions, the surviving spouse shouldbe deemed to have made a transfer,the terms of which make it possi-ble for a special power to be con-ferred on him or her, thereby trig-gering Section 2038 should thespecial power in fact then be grant-ed to the surviving spouse.

QTIP toggling with GST tax plan-ning. Another advantage of tog-gling planning with QTIP trusts isthat it is compatible with GST taxplanning. Specifically, the first dece-dent’s executors may make a“reverse” QTIP election under Sec-tion 2652(a)(3) and allocate thefirst decedent’s GST exemption tothe trust. Even if the surviving

spouse later toggles gross estateinclusion off by assigning theincome interest, the first decedentwill continue to be treated as thetransferor of the QTIP principal forGST tax purposes.83 Thus, the sur-viving spouse will not need to allo-cate any of his or her own GSTexemption in order for the QTIPproperty to preserve its exemptionfrom GST tax.

In addition, although it is notcertain, it seems that the first dece-dent rather than the survivingspouse should be considered thetransferor for GST tax purposes ofthe income paid over to the doneesof the income interest.84 Thus, if theincome interest is assigned to skippersons or to a trust for the bene-fit of skip persons, the incomeshould be protected from GST taxby the first decedent’s GST exemp-tion. Even if the surviving spouseis considered the transferor of trustincome for GST tax purposes, itseems that the value of the gift ofthe income interest would be smallcompared to the value of the QTIPtrust as a whole. Consequently, verylittle of the surviving spouse’s GSTexemption should need to be allo-cated to the gift in order to protectit from GST tax.

Toggling as a planning alternativeEstate planning for married couplesis conventionally framed as a choicebetween two alternatives, namely,a traditional credit shelter trust ora portability election.85 In this view,a couple can opt either for a tradi-tional credit shelter trust plan, orelse may rely on the portability pro-visions of Section 2010(c). Whichof the two is the better choicedepends on a variety of factors andcircumstances. Financial models areoften constructed in order to“prove” that one plan or the otheris superior, at least in the majorityof the cases.86 Of course, the “proof”that, say, a credit shelter trust out-

performs portability in the majori-ty of cases is small comfort to thosein the minority who, in retrospect,conclude that they should haverelied on portability.

Happily, it seems that portabil-ity versus credit shelter trust plan-ning is a false dilemma. As dis-cussed, it is possible, through aQTIP trust with toggling provi-sions, to permit the survivingspouse to choose, at any time afterthe first decedent’s death, betweenhaving the trust property includ-ed in his or her gross estate, or elsehaving the trust use up the firstdecedent’s estate tax exclusionamount and pass outside of the sur-viving spouse’s gross estate. In otherwords, the surviving spouse caneffectively choose, at any time afterthe first decedent’s death, betweenthe equivalent of a credit sheltertrust plan and a portability plan.

Toggling even creates uniqueadvantages: Only with toggling, forexample, is it possible to purge fromthe couple’s combined estate and giftbase the initial transfer that wouldhave used up the first decedent’sexclusion amount, if it turns out thatthe transferred property declines invalue. Toggling, in short, representsa third alternative that combines theadvantages of both credit sheltertrust and portability planning.

ConclusionThrough the use of Section 2038,it seems possible to cause proper-ty transferred during lifetime to bepulled back into a decedent’s grossestate at death, should that be themost tax-efficient result. Togglingcan also be combined with QTIPtrusts in order to substantiallyenhance the planning flexibility formarried couples. Estate plannersand their clients, especially mar-ried clients, should seriously con-sider incorporating toggling pro-visions into their standard estateplanning documents. ■

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