QTIP Trust Liabilities and Estate Tax: Lessons (and More Questions) From the Kalikow Decision

This followed a stipulation in litigation that fixed the value of the QTIP trust without taking into account any reduction in value attributable to the estate’s claim against it for undistributed income. The court also affirmed that the claim was not eligible for a deduction as an administration expense under section 2053(b) of the Internal Revenue Code (IRC). While the Second Circuit issued its opinion last year, this case has recently been the focus of many in the estate planning community.

The Kalikow case highlights the complex interplay of estate taxation between marital trusts and the estate of the survivor, as described below. It also raises concerns for estate and tax planning professionals when a QTIP trust is subject to debt and raises flags concerning stipulations in a litigation context with the Internal Revenue Service. 

Factual Background

The SK Trust and Pearl’s Will

Pearl B. Kalikow, a resident of New York, passed away on January 4, 2006. Pearl’s husband, Sidney Kalikow, predeceased her. Article Third of Sidney’s will established a QTIP trust known as the SK Trust. The executors of Sidney’s estate elected to treat the SK Trust as a QTIP trust under section 2056(b)(7) of the IRC.

The trustees of the SK Trust were directed to pay the trust’s net income to Pearl at least quarterly during her lifetime and were authorized to make discretionary distributions of principal to her. Upon her death, the SK Trust terminated and the remaining trust principal was distributed to separate trusts for the primary benefit of Sidney and Pearl’s children, Edward Kalikow and Laurie Platt (the “Children’s Trusts”). 

The SK Trust was initially funded with interests in 10 income-producing apartment buildings in New York City. The then-trustees of the SK Trust subsequently created the Kalikow Family Partnership L.P. (KFLP) and transferred such interests in the apartment buildings to KFLP in exchange for a 98.5% limited partnership interest. At the time of Pearl’s death, the SK Trust held the KFLP limited partnership interest and approximately $835,000 in cash and marketable securities. In litigation, the parties stipulated that the value of the SK Trust’s 98.5% interest was $54,492,712. Thus, according to section 2056(b)(7) of the IRC, Pearl’s estate included an additional $55,327,712 in value representing the SK Trust’s assets.

Pursuant to Pearl’s will, the SK Trust was responsible for its share of estate tax arising from the inclusion of the SK Trust property in her taxable estate. After the payment of estate tax, and various specific bequests, the residue of Pearl’s estate was bequeathed to the Sunshine Foundation, a charitable organization. 

The Dispute

During administration of Pearl’s estate, a disagreement arose with respect to the trustee’s administration of the SK Trust. Notably, the objectants alleged that KFLP failed to distribute its full share of KFLP’s distributable amounts to the SK Trust, which deprived Pearl of her proper receipt of trust income. After 10 years of litigation, the parties agreed to a $6,572,310 settlement payment from the SK Trust to Pearl’s estate. The SK Trust and the Children’s Trusts were made jointly and severally liable for payment of this.

Notice of Deficiency

The focus of the Tax Court proceedings was the effect of the settlement on the value of the SK Trust assets included in Pearl’s gross estate. By notice of deficiency, the commissioner determined an estate tax deficiency against the estate based on differing valuations of the SK Trust. The petitioners, Edward and Laurie, in their role as limited administrators for the estate, subsequently advanced two theories for reducing the estate’s tax liability: (1) the value of the SK Trust assets included in Pearl’s gross estate under section 2044 of the IRC should be reduced by the agreed upon undistributed income amount, and (2) the amount should be deductible from the gross estate as an administrative expense under section 2053 of the IRC. The Tax Court rejected both arguments and the court affirmed. 

The Second Circuit’s Analysis

Inclusion of the SK Trust Assets in Pearl’s Estate

As noted above, Sidney’s executors elected to treat the SK Trust as a QTIP trust under section 2056(b) of the IRC. Pursuant to section 2044(a) of the IRC, the SK Trust property was included in Pearl’s estate at its fair market value as of the date of her death. The question presented to the court was whether the settlement liability should reduce the fair market value of the assets held by the SK Trust and, as a result, the value to be included in Pearl’s estate. 

The petitioners claimed that the value of KFLP should indeed be reduced by the amount of the settlement. The effect, they argued, is that the value attributable to the SK Trust would be reduced by $6,572,310 and the value of Pearl’s estate increased by the same amount.

The court was unpersuaded. It found no basis to conclude the liability would affect the market value of KFLP, as the settlement imposed joint and several liability on the SK Trust and the Children’s Trusts (not the entity itself). Moreover, it held that the liability would have no impact on the price of the partnership interest between a hypothetical willing buyer and seller as the purchaser would not accede to the SK Trust’s liability. In other words, the SK Trust was a separate entity and a liability belonging to it would not encumber its underlying assets. 

Double Taxation

The petitioners also asserted that the inclusion of the settlement in Pearl’s estate would result in impermissible double taxation. The court disagreed, noting that the residue of Pearl’s estate passed to charity and would not be subject to estate tax.

Deductibility Under Section 2053

Section 2053(a) of the IRC permits a deduction for certain amounts, to include administration expenses and claims against the estate, that are permitted under relevant state law. Section 2053(b) generally allows a deduction for expenses incurred in administering non-probate property, such as property held in a QTIP trust, to the same extent as they would be deductible under 2053(a). Pursuant to Treas. Reg. 20.2053-3(a), the expense must be “actually and necessarily, incurred in the administration of the decedent’s estate; that is, in the collection of assets, payments of debts, and distribution of property to the persons entitled to it.” 

The petitioners argued the estate should be entitled to a deduction in the amount of the settlement payment. The court disagreed, holding the entity responsible for paying the settlement amount was the SK Trust, not the estate. The settlement was an asset based on income owed to Pearl during her lifetime and property to be included in her estate. The court acknowledged its conclusion remained even though the liability was borne by an entity that held assets included in Pearl’s taxable estate. 

Analysis

The holding in Kalikow is potentially troubling for estate and tax planners alike as it raises concerns surrounding the administration and taxation of QTIP trusts. The result was influenced by various factors that should serve as lessons to estate planners. 

First, the court emphasized that the parties stipulated the value of the SK Trust’s interest in KFLP as $54,492,712, even with knowledge of the undistributed income claim. It held that the parties could not subsequently argue for a lesser value on account of the undistributed income payment liability. Indeed, the value stipulated by the parties was the value includible for purposes of section 2044 of the IRC. As a result, the court was not inclined to accept another valuation. 

Second, the settlement agreement provided for payment from “readily available funds” of the SK Trust without having to liquidate the underlying properties of KFLP. Accordingly, there was no expectation that properties would be affected by the claim. Further, Edward and Laurie represented and guaranteed that the assets of the SK Trust and their respective Children’s Trusts were sufficient to cover the settlement. In the event there was a shortfall in liquid assets, Edward and Laurie would fund the SK Trust and Children’s Trust with a sufficient amount. This outcome may have been avoided had KFLP been explicitly liable for the payment. In that case, it could have reduced its balance sheet and its ultimate value. 

Additional Takeaways for Estate Planners

The Kalikow decision has questionable precedential value in light of the stipulation that fixed the value of the QTIP trust and, moreover, was issued as a summary order by the Second Circuit that, by its terms, is technically without precedential effect. Nevertheless, certain lessons can be gleaned from it. For example, trustees must ensure timely and complete income distributions as required by QTIP trusts, as failures to do so can generate disputes among beneficiaries and significant tax consequences. In addition, because assets in the QTIP trust may increase estate tax liability upon the second death, proactive estate and tax planning is critical. 

To further complicate matters, a QTIP trust and the surviving spouse’s estate may have different beneficiaries. Shifting value from the QTIP trust to the estate may also shift which party bears the estate tax burden. In Kalikow, the residuary beneficiary of Pearl’s estate was a charity. Careful estate and tax planning is essential to determine which entity should bear the brunt of such liability, especially when beneficiaries differ.