QTIP Trust a ‘Tax Trap?’

Take-Away: When a surviving spouse of a qualified terminable interest trust (QTIP) moves to another state, there is the risk that the new domicile state may impose a state estate tax on the QTIP trust’s assets.

Background: A couple of years ago the U.S. Supreme Court had the opportunity to review the necessary connections a state must have before it can impose a tax on a trust’s income. In North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trusts, 139 S. Ct. 2213 (2019) the Court held that under the Due Process Clause, North Carolina could not tax trust income over a four year period when: (i) the trust was administered under New York law, (ii) by a New York trustee; (iii) where all trust assets were held outside North Carolina and (iv) while all beneficiaries lived in North Carolina,  no distributions were actually made to any of those beneficiaries. The Court held that there were insufficient connections with North Carolina to permit it to tax undistributed trust income. However, the Court left the door open as to the nature of other connections a resident trustee or trust beneficiary might have that would permit a state to tax trust income. While Kaestner was an income tax case, in the last two years two other cases were reported in which a state successfully sought to impose its state estate tax on a resident’s interest in a qualified terminable interest trust, or QTIP trust.

Shaffer v. Commissioner, Supreme Judicial Court of Massachusetts (July 10, 2020)

Facts: Adelaide was the beneficiary of a QTIP trust established by her late husband Robert. Robert died a New York resident. Robert’s estate filed estate tax returns on which a timely QTIP election was made, under both federal and New York law. The QTIP trust only held stock in corporations and a limited partnership interest. Adelaide died a Massachusetts resident in 2011. The QTIP trust assets were included as part of Adelaide’s federal estate on Form 706, but the QTIP trust assets were omitted on her Massachusetts’ estate tax return. Adelaide’s estate did not file a New York estate tax return. Massachusetts calculates its state estate tax with refence to the federal estate tax, a so-called sponge tax; the state estate tax is imposed on the “transfer of an estate of each person dying… a resident of the commonwealth.”

Assessment: Massachusetts assessed an additional state estate tax of almost $2.0 million that related to the value of the QTIP trust. Adelaide’s estate argued that there was no transfer; the only transfer of assets occurred at the time of Robert’s death, a New York resident. As a result, her estate argued that it was a violation of constitutional principles to tax the QTIP trust at Adelaide’s death.

Court Decision: The court found that there was a transfer on the death of the surviving spouse under the QTIP trust. It found that a transfer occurs whether there is a change in the legal and economic relationship as to the property held in the trust. According to the court, a transfer had occurred on Adelaide’s death with respect to the QTIP trust property because there was a change in the legal and economic relationships to the QTIP trust property.

Appeal: Adelaide’s estate has petitioned for write of certiorari to the U.S. Supreme Court, in which the estate argues that Massachusetts violates the Due Process Clause by taxing the QTIP trust given its broad interpretation of what is a transfer sufficient to impose a state transfer tax.

Estate of Evans v. Department of Revenue, 368 Or. 430 (July 29, 2021)

• Facts: Unfortunately, the facts in this case are a bit more cumbersome. Helene was the beneficiary of her late husband, Gillam’s, QTIP trust. Gillam died in 2012 a resident of Montana. The QTIP trust was governed by Montana law. Gillam’s son was the trustee, also a Montana resident. The trust did not start out as a QTIP trust. Rather, the personal representative of Gillam’s estate petitioned a Montana court to modify the trust to permit a QTIP election to be made,  which petition was approved. The revised trust provided that Helene would receive all of the trust income for life, and principal could be distributed to her by the trustee for her health, maintenance and support in her accustomed manner of living. Helene did not hold a power of appointment over the QTIP trust. Gillam’s estate filed a federal estate tax return and made a QTIP election. Montana did not impose a state estate tax, so no state estate tax return was filed by his estate.

In 2014 Helene sought an additional distribution from the trust in Montana courts. As a result, she reached a settlement with the QTIP trustee. Helene received a lump sum payment from the trust and then a fixed monthly annuity payment from the trust for her life. Helene died in 2015 a resident of Oregon. On the Oregon estate tax return, Helene’s estate reported the QTIP trust as required by Oregon law. However, later on, Helene’s estate sought to exclude the value of the QTIP trust assets and it filed for a refund of the state estate tax paid.

Claim: Helene’s estate claimed that Oregon’s tax on the QTIP trust’s assets violated the Due Process Clause. Specifically,  the estate claimed that the Due Process Clause does not permit a state to impose an estate tax on a trust that holds intangible assets solely because the resident of the state was an income beneficiary during her lifetime, where the beneficiary held no control or right over the trust assets. Thus, the question before the Oregon court was whether the resident (Helene) had the necessary connections in or to the intangible property held in the QTIP trust.

Court Decision:  The Oregon court distinguished the Kaestner. It found that while holding a power or right may be sufficient to establish a connection that permits a state to impose its tax, such a connection is not a prerequisite. Other forms of ‘possession, control or enjoyment’ may also satisfy the Due Process Clause. The court found that Helene’s beneficial interests in the trust, both income and principal, qualified as a “substantial measure of enjoyment” which allowed Oregon to tax the trust as part of her estate.

Question: By switching from an right to income to an annuity distribution (a unitrust), which might have resulting in the automatic payment of trust principal to Helene, was that act sufficient to expose the QTIP trust assets to Oregon’s state estate tax? Arguably the trust’s modification to an annuity distribution gave Helene a right to receive some portion of trust’s principal, even if it was in the form of intangible personal property.

Conclusion: While the Kaestner decision focused on North Carolina’s lack of contacts with the trust in question, finding the state residency of the trust beneficiaries, standing alone, was an insufficient contact to justify the right to impose a tax, the Supreme Court also suggested that other contacts between the trust, or the trust beneficiary with the state, might satisfy any due process concerns. The Shaffer (transfer)and Evans (substantial measure of enjoyment) decisions are strong indications that states with state estate taxes will aggressively find that other contacts exist that will be sufficient to permit the imposition of a state tax. On a more practical level, consider a surviving spouse who may be the lifetime beneficiary of a QTIP trust established by her late Michigan husband. The widow decides to move to Oregon to be closer to her son and grandchildren. Presumably if the widow had remained a Michigan resident and died, no state estate tax would be imposed. Yet, simply by moving across the country to be closer to her son and grandchild, a state estate tax will be imposed on the widow’s death, because she had “a substantial measure of enjoyment” from the QTIP trust.