Davis v. C.I.R.

• Decision Date: 24 January 2005
• Docket Number: No. 03-72240.,03-72240.
• Citation: 394 F.3d 1294
• Parties: Ralph H. DAVIS; Evelyn Davis, Personal Representative, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

394 F.3d 1294

Ralph H. DAVIS; Evelyn Davis, Personal Representative, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 03-72240.

United States Court of Appeals, Ninth Circuit.

Submitted December 10, 2004.^*

Filed January 24, 2005.

Richard S. Calone, Jason W. Harrel, Richard S. Calone, LLP, Stockton, CA, for the petitioner-appellant.

Eileen J. O'Connor, Assistant Attorney General, Jonathan S. Cohen, Karen D. Utiger, Tax Division, Department of Justice, for the respondent-appellee.

Appeal from a Decision of the United States Tax Court. IRS No. 210-02.

Before: FARRIS, D.W. NELSON, and GOULD, Circuit Judges.

GOULD, Circuit Judge.

Petitioner Evelyn L. Davis, the personal representative of the estate of her late husband, Ralph H. Davis, appeals a Tax Court decision upholding the determination of a deficiency in the taxes paid on the Davis estate. Mrs. Davis claims that the terms of an amended trust included in the Davis estate give her an unrestricted right to all of the trust income for life, and that her interest in the trust income qualifies for a marital deduction pursuant to Internal Revenue Code section 2056(b)(7). We have jurisdiction pursuant to 26 U.S.C. section 7482(a), and we affirm.

I

On February 24, 1993, decedent Ralph H. Davis executed both a "Will" and a "Declaration of Trust." The Will bequeathed the residue of the decedent's estate to his daughters, Carol Tawney Pencke and Mary Martha Bennett. The Declaration of Trust stated that during Ralph H. Davis's lifetime, "he shall be entitled to all of the net income ... from the trust estate, payable in convenient installments, and he may withdraw such sums as he desires from principal at any time or times." The Declaration of Trust also named Pencke and Bennett as successor beneficiaries following the death of Ralph H. Davis. If either daughter predeceased Mr. Davis, her interest would pass to her descendants, per stirpes.

The decedent then married Evelyn L. Davis, and on April 9, 1996 subsequently executed a "Codicil" and an "Amendment to Declaration of Trust" ("Amendment"). The Amendment stated in part:

2. Life Estate to Surviving Spouse of Trustor: After the death of trustor survived by his spouse and during the lifetime of his surviving spouse, the trustee shall pay to or apply for the benefit of the surviving spouse, in quarter annual or more frequent installments, all of the net income from the trust estate as the trustee, in the trustee's reasonable discretion, shall determine to be proper for the health, education, or support, maintenance, comfort and welfare of grantor's surviving spouse in accordance with the surviving spouse's accustomed manner of living.

3. Designation of Successor Trustees: The first successor trustee of the Ralph H. Davis Trust shall be his spouse, Evelyn L. Davis. In the event Evelyn L. Davis shall die, become incapacitated or otherwise be unable to administer the trust estate, then grantor's daughters, Carol Tawney Pencke and Mary Martha Bennett, or the survivor of them shall serve as co-trustees without bond.

4. Guideline — Other Sources: Beneficiary: In making distributions to grantor's surviving spouse, the trustee, in her reasonable discretion, may consider any other income or resources of the beneficiary known to the trustee and reasonably available.

5. Invasion of Principal for Surviving Spouse — Narrow Standard: If the trustee shall determine that the income from this trust and that the income and principal from the surviving spouse's own trust shall be insufficient to maintain surviving spouse's health, support and maintenance, the trustee may, after surviving spouse has exhausted all assets of her own trust, invade the principal of this trust for the benefit of surviving spouse, in the trustee's reasonable discretion.

Ralph H. Davis died on July 14, 1997, leaving a gross estate of $1,180,823.00. Mrs. Davis, as the personal representative of the Davis estate, claimed a marital deduction in the amount of $573,216.00 under Internal Revenue Code sections 2056(a), 2056(b)(5) and 2056(b)(7).

The Commissioner reduced the marital deduction by $564,862.00, allowing the estate to deduct only $8,354.00 in life insurance proceeds that passed directly to the surviving spouse and disallowing the deduction for the funds passing in the amended trust. The Commissioner issued a notice of deficiency in the amount of $220,593.00. The estate appealed the determination of deficiency to the Tax Court, which held for the Commissioner. On this appeal, Mrs. Davis has abandoned her claim for a deduction under section 2056(b)(5), but continues to claim that the terms of the Amendment qualify for a marital deduction under section 2056(b)(7).

II

Under the Internal Revenue Code, the taxable estate of a decedent is computed by taking the gross estate defined in section 2031 and subtracting the deductions listed in sections 2053, 2054, 2055 and 2056. I.R.C. § 2051. Section 2056 describes the marital deduction.¹ Although property passing from a decedent to a surviving spouse generally qualifies for a marital deduction from the federal estate tax, I.R.C. § 2056(a), life estates and other terminable interests passing to a surviving spouse are not deductible unless they qualify for an exception under section 2056(b)(5) or section 2056(b)(7). I.R.C. § 2056(b)(1).²

To qualify for a marital deduction under section 2056(b)(7), a marital trust must consist of property"(I) which passes from the decedent, (II) in which the surviving spouse has a qualifying income interest for life, and (III) to which an election under [section 2056(b)(7)] applies." I.R.C. § 2056(b)(7)(B)(i). A deduction under section 2056(b)(7) is also known as a Qualified Terminable Interest Property, or QTIP, deduction. A surviving spouse has a "qualifying income interest for life" if he or she is "entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property," and "no person has a power to appoint any part of the property to any person other than the surviving spouse." I.R.C. § 2056(b)(7)(B)(ii).

The Treasury Regulations elaborate on the requisite degree of control required to claim a QTIP deduction: A surviving spouse is "entitled for life to all of the income" if he or she is "unqualifiedly designated as the life beneficiary of a trust." Treas. Reg. § 20.2056(b)-5(f)(1).³ He or she "must have such command over the income that it is virtually hers."⁴ Treas. Reg. § 20.2056(b)-5(f)(8). To meet these standards, a surviving spouse must show that he or she "(i) is entitled to the income until the trust terminates, or (ii) has the right, exercisable in all events, to have the corpus distributed to her at any time during her life." Treas. Reg. § 20.2056(b)-5(f)(6). A trust does not qualify for a QTIP deduction "to the extent that the income is required to be accumulated in whole or in part or may be accumulated in the discretion of any person other than the surviving spouse ..." Treas. Reg. § 20.2056(b)-5(f)(7).

In Estate of Ellingson v. Commissioner, we considered a "Marital Deduction Trust" that named the surviving spouse as a co-trustee and provided that "if the income so payable to the Surviving Settlor shall, at any time or times, exceed the amount which the Trustee deems to be necessary for his or her needs, best interests and welfare, the Trustee may accumulate the same, as the Trustee deems advisable." 964 F.2d 959, 960 (9th Cir.1992). We concluded that, under the circumstances in that case, the "best interests and welfare" language was sufficiently broad to entitle the surviving spouse "to all the income from the property" for life under section 2056(b)(7)(B)(ii)(I). Id. at 964-65. In dicta, we noted that other language, such as "necessary or proper to provide for ... care, comfortable maintenance, and support and reasonable comfort" and "usual and customary standard of living" would not fall within the terms of section 2056(b)(7) because "reformation of the interest-creating instrument would [be] required to grant the QTIP deduction." Id.; see also Estate of Rapp v. Comm'r, 140 F.3d 1211, 1213, 1218 (9th Cir.1998) (holding insufficient for QTIP purposes a trust that gave surviving children discretion to distribute income to provide for the surviving spouse's "health, education and support"); Wisely v. United States, 893 F.2d 660 (4th Cir.1990); Estate of Nicholson v. Comm'r, 94 T.C. 666, 668-74, 1990 WL 52664 (1990).

When a decedent chooses to limit the degree of control that his or her surviving spouse has over the income from a terminable interest property, the decedent also precludes the possibility that his or her estate may claim a QTIP deduction under section 2056(b)(7). A section 2056(b)(7) marital deduction is available only when a decedent leaves a surviving spouse complete control over the income from a property for life.⁵ Conversely, if a surviving spouse's interest in the property income is limited and thus cannot be equated with virtual ownership, an estate may not claim a marital deduction under section 2056(b)(7).⁶

III

We next consider whether the interest granted to Evelyn L. Davis under the Declaration of Trust and the Amendment qualifies for a marital deduction under section 2056(b)(7).

In determining whether an interest that passes in trust to a surviving spouse qualifies for a QTIP deduction under section 2056(b)(7), we first look to state law to determine the nature and extent of the property interest granted to the surviving spouse, and then turn to federal law to determine whether these property rights are ultimately subject to taxation. United States v. Craft, 535 U.S. 274, 278, 122 S.Ct. 1414, 152 L.Ed.2d 437 (2002) (quoting Drye v. United States, 528 U.S. 49, 58, 120 S.Ct. 474, 145 L.Ed.2d 466 (1999)); Estate of Heim v. Comm'r, 914 F.2d 1322, 1327 (9th Cir.1990).⁷

A

We first examine how California law views...