ESTATE TAX GROSS-UP OCCURS FOR GIFT TAXES PAID UNDER SECTION 2519 WITHIN 3 YEARS OF DEATH

[NOTE: This is a technical issue that is probably of interest to only a small subset of the readers of this blog. For more information on Section 2519, you can review my article from earlier this year entitled Tax Results of Settling Trust Litigation involving QTIP Trusts published in the January 2009 edition of Estate Planning, a WG&L publication. I will also be speaking on the same subject in January 2010 at the Heckerling Institute on Estate Planning.]

Section 2519 of the Internal Revenue Code imposes a gift tax when all or a portion of a QTIP trust (a specific type of marital deduction trust established by one spouse for another to reduce estate and/or gift taxes) is distributed during the lifetime of the beneficiary spouse to beneficiaries other than the spouse. The gift taxes are payable by the spouse – however, the spouse can “recover” the taxes from the beneficiaries who receive the assets of the trust that triggered the tax.

Section 2035(b) requires that any gift taxes paid by a decedent within 3 years of death be added to the gross estate of the decedent for purposes of computing estate taxes. In a recent Tax Court case, the issue arose whether gift taxes paid under Section 2519 are subject to this 3 year gross-up rule for the gift taxes paid within 3 years of the spousal beneficiary’s death.

The estate made a strong argument that the gross-up rule should not apply, at least when the spouse exercised her rights to recover the gift taxes arising under Section 2519 from the other trust beneficiaries. This is because the Section 2035(b) gross-up rule applies only to gift taxes of the spouse, and in this circumstance the substance of the transaction is that the other beneficiaries of the QTIP trust paid the gift tax.

The Tax Court was not persuaded by the estate’s argument, and held the gross-up ruled applied. The Court noted that under the Code, the gift tax is imposed on the spouse. The “right of recovery” of the spouse is just that – and is not technically a shift in who is primarily liable for the tax.

The Court noted that to rule otherwise would violate the policy of Section 2035(b) which is to prevent death bed transfers that would incur gift tax, and thus remove the gift taxes themselves from being subject to estate tax on the subsequent death of the grantor. The Court believed that if the gift tax incurred under Section 2519 was not covered by the gross-up rule, spousal beneficiaries of QTIP trusts would have the incentive to terminate the trusts prior to death (where death is foreseeable) so as to avoid estate taxes on the amount of gift taxes incurred.

Estate of Anne W. Morgens, et vir. v. Commissioner, 133 T.C. No. 17 (December 2009)