A recent Tax Court case, Estate of Olsen v. Comm’r, T.C. Memo 2014-58, demonstrates the importance of proper trust funding after the first spouse’s death. In Olsen, a married couple established two revocable trust agreements during their lives as their primary estate planning documents. At the first spouse’s death, each trust agreement required certain new trusts to be created and funded: a trust to hold the first spouse’s assets up to the federal estate tax exemption amount (often known as a credit shelter trust), and the remaining two trusts to qualify for the federal estate tax marital deduction (often known as QTIP trusts). The credit shelter trust would escape estate taxation at the surviving spouse’s death, but the QTIP trusts are required to be included in the surviving spouse’s estate.
When the first spouse, Grace, passed away, the surviving spouse, Elwood, an attorney and college vice president, did not transfer any of Grace’s revocable trust assets to the credit shelter or QTIP trusts. Instead, he continued to hold those assets in Grace’s revocable trust, although he did report that the trusts were funded on the federal estate tax return. During Elwood’s life he made several large withdrawals from Grace’s trust.
After Elwood passed away, the Personal Representative of Elwood’s estate took the position that the credit shelter and QTIP trusts had in fact been funded. The IRS disagreed, initially arguing that the entirety of Grace’s trust was includible in Elwood’s estate. The parties eventually stipulated that only the QTIP portion of Grace’s trust was includible in Elwood’s estate. The issue before the Tax Court was how to divide Grace’s trust into QTIP and credit shelter portions, since Elwood had failed to fund the trusts during his life and had made large withdrawals from Grace’s trust.
The Tax Court determined that two of the large withdrawals, which Elwood donated to charity, were properly allocable to the credit shelter trust, and the smaller withdrawal, which Elwood deposited in his own account, was properly allocable to the QTIP trusts. The estate had argued that Elwood and Grace intended to minimize estate taxes, and because allocating all of the withdrawals to the QTIP trusts minimized tax, that is how Elwood intended the withdrawals to be allocated. The Tax Court disagreed, reasoning that only the credit shelter trust provisions granted Elwood a limited power of appointment in favor of charitable organizations, despite the fact that both the credit shelter and QTIP trust provisions allowed Elwood to distribute trust principal to himself.
The Olsen case is an example of an unfortunately common scenario – spouses implement an estate plan designed to minimize estate tax, but the surviving spouse fails to take the necessary steps after the first spouse’s death to implement such plan. While the IRS in Olsen eventually agreed that the trust planning should be respected even if the surviving spouse failed to fund the trusts, Elwood’s estate underwent an undoubtedly expensive audit before the IRS did so. Additionally, it seems possible that had the trusts been properly funded, Elwood’s large withdrawals would have been made from the QTIP trusts and not the credit shelter trust, thereby reducing the estate tax due at Elwood’s death, as he and Grace intended. The lesson of Olsen is that even the most sophisticated clients should seek counsel as soon as possible following a family member’s death, particularly a spouse’s death.