Taxes in your practice: US Tax Court holds children liable for gift tax on termination of family trust

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.

The U.S. Tax Court recently held residuary beneficiaries of a trust liable for gift taxes upon termination of the trust and established the values of those gifts.

In McDougall v. Commissioner,¹ the tax court found that when a surviving husband and children terminated the trust and distributed all assets to the husband, the children made taxable gifts to their father. In Lewis v. Commissioner,² the tax court addressed the valuation of these gifts.

Background

Clotilde McDougall died in December 2011, leaving a testamentary residuary trust consisting primarily of shares in a family real estate business. The residuary trust provided for distribution of income to her surviving husband, Bruce McDougall, during his life and distribution of principal in the trustee’s discretion for Bruce McDougall’s health, maintenance, and support in his accustomed manner of living.

Bruce McDougall had a testamentary power to appoint the principal among Clotilde McDougall’s descendants. To the extent Bruce McDougall did not make such appointments, the remainder of the residuary trust on Bruce McDougall’s death was to be divided into equal shares for the children of Clotilde and Bruce McDougall, Linda Lewis and Peter McDougall, “one share for each of [Clotilde McDougall’s] children who is then living and one share for each of [her] children who is then deceased with children then living.”³

The residuary trust provided that upon termination the remaining assets were to be distributed among its beneficiaries so that “the distributees receive assets of a value equal to the value of their respective interest in the trust at the time of distribution.”⁴ The trust also included a spendthrift clause providing that beneficiaries did not have power to give or otherwise dispose of their interest in the trust estate.

As the personal representative of Clotilde McDougall’s estate, Bruce McDougall made a qualified terminal interest property (QTIP) election with respect to the property in the residuary trust. Bruce McDougall also executed a will purporting to exercise his power of appointment under the residuary trust.

In 2016, Bruce McDougall, Peter McDougall, and Lewis entered a nonjudicial agreement terminating the residuary trust and distributing all the assets to Bruce McDougall.

In McDougall, the tax court held that Lewis and Peter McDougall made taxable gifts by directing trust assets to Bruce McDougall that they were otherwise entitled to receive, but the tax court did not set a valuation for the gifts.

For purposes of Lewis, the parties stipulated that these assets had a value of $117,604,143 at the time the trust was terminated. However, Lewis and Peter McDougall argued the gifts had only nominal value because of Bruce McDougall’s limited power of appointment.

They relied on a valuation expert who testified that each gift should be valued at $156,000. In making his calculations, the valuation expert treated Bruce McDougall as being 80 years old rather his actual age of 85 because of Bruce McDougall’s high level of income and used a discounted cash flow method to value the remainder interests held by Lewis and Peter McDougall. The valuation expert also discounted the value of the potential future distributions due to Bruce McDougall’s lifetime income interest.

The IRS valued the gifts by Lewis and Peter McDougall at $53,408,746 each and disregarded Bruce McDougall’s limited power of appointment because it was eliminated upon termination of the trust. The IRS argued that elimination of Bruce McDougall’s limited power of appointment by the nonjudicial agreement changed the remainder interests held by Lewis and Peter McDougall to prototypical property interests to be valued under the standard actuarial factors under Internal Revenue Code § 7520.

The IRS also maintained that the value of these gifts should not be reduced by the obligation Lewis and Peter McDougall may have under § 2207A for reimbursement of gift taxes.

Statutory background

Code § 2501(a)(1) imposes tax on transfer of property by gift, which applies regardless of the nature of the transfer or the property. Section 2512(a) provides that a transfer of property by gift is valued on the date of the gift. Section 2056 allows QTIP to qualify for the marital deduction, avoiding estate tax upon the first spouse’s death.

QTIP is property (1) that passes from a predeceasing to a surviving spouse, (2) in which the surviving spouse has an interest for life, and (3) in respect of which a QTIP election is made.⁵

Under the QTIP rules, a surviving spouse or their estate can be subject to gift or estate taxes on transfers that do not occur. Section 2207A provides that the surviving spouse or their estate can recover those taxes from the parties who own the property in question.

Section 7520 requires that the value of specified property interests, including remainder interests, must be determined under prescribed tables using an interest rate equal to 120% of the federal midterm rate in effect for the month of the valuation date. Section 7520 tables also use different rates based on the age of the life beneficiary. These standard actuarial factors in § 7520 tables are not to be used to value a “restricted beneficial interest,”⁶ which means a remainder interest subject to any contingency, power, or other restriction, whether by the terms of a trust, will, or other circumstances.

Tax court analysis

In McDougall, the IRS argued that termination of the residuary trust resulted in taxable gifts (1) by Bruce McDougall to Lewis and Peter McDougall and (2) by Lewis and Peter McDougall to Bruce McDougall. The tax court found that Bruce McDougall, as surviving spouse, ended up owning the property he was deemed to own under the QTIP rules prior to termination of the trust. As a result, he was not subject to a taxable deemed transfer under § 2519.

In contrast, the tax court found that Lewis and Peter McDougall plainly made gratuitous transfers of valuable remainder interests they held in the QTIP. The court confirmed in McDougall that the value of the gifts Lewis and Peter McDougall made to Bruce McDougall would equal the value of the distribution to which they would have been entitled under Clotilde McDougall’s will upon termination of the residuary trust if they had not agreed to distribute all trust property to Bruce McDougall in the nonjudicial agreement.

In Lewis, the valuation of these gifts was before the tax court. As noted, the taxpayers argued that the gifts had only nominal value, and the IRS argued that each gift should be valued at $53,408,746. The tax court took its own approach under the statutory framework and the terms of Clotilde McDougall’s will.

The court focused on three primary issues: (1) whether the value of the gifts should be reduced by reason of Bruce McDougall’s limited power of appointment, (2) whether those gifts should be reduced by operation of § 2207A, and (3) whether the value of the gifts should be determined by tables under § 7520.

The tax court first reviewed the testamentary limited power of appointment. While the court disagreed with the approaches of both parties, it did find that the power of appointment should be disregarded by giving effect to Clotilde McDougall’s will. The court found that allocating the residuary trust assets pursuant to Clotilde McDougall’s will required giving effect to her intention to leave a substantial remainder interest for her children rather than leaving the assets outright to Bruce McDougall, as was later effectuated by the nonjudicial agreement. The will thus reflects Clotilde McDougall’s preference that Bruce McDougall was not to have outright ownership of her share of her family business.

The court concluded that valuing the beneficiary’s interests in the residuary trust at the time of its termination would have resulted in distributing assets in equal shares to Lewis and Peter McDougall. Under this approach, the court found that the gifts had a value of at least $34.9 million each.

The tax court next considered the impact of § 2207A. The court noted the gifts should be valued by determining what would have happened if the parties had agreed to terminate the residuary trust without specifying a distribution of assets. Under this approach, the court concluded the petitioners, Lewis and Peter McDougall, would have been entitled, under the will, to assets with a value equal to their remainder interests. If those distributions had occurred, Bruce McDougall would have been liable for gift tax and entitled to recover that tax from Lewis and Peter McDougall under § 2207A.

The IRS argued these § 2207A reductions in value were hypothetical. But the court disagreed, holding that the value of the gifts by Lewis and Peter McDougall to Bruce McDougall should be reduced by the obligation to Bruce McDougall that they would have had under § 2207A if they had received distributions of trust assets under Clotilde McDougall’s residuary trust.

Under this consideration, the court found each gift was worth no more than $38,149,104.

The court then turned to the application of § 7520 valuation tables. The IRS argued the nonjudicial agreement eliminated Bruce McDougall’s limited power of appointment and transformed the remainder interests in the residuary trust into prototypical property interests that should be valued under § 7520 tables. The court instead found the beneficiaries’ entitlement to the trust was a matter of state law. The IRS had conceded that, under those circumstances, each gift would have a value of no more than $35,141,321, and the court found Bruce McDougall’s life expectancy should be determined on his actual age to confirm that valuation.

Based on this conclusion, the court issued the following holdings:

• Because Clotilde McDougall’s will must be interpreted to effect her intent, if the parties had terminated the residuary trust without specifying how the trust assets should be distributed, the distributions to which Lewis and Peter McDougall would have been entitled would not have been reduced due to Bruce McDougall’s limited power of appointment.
• Because the distributions Lewis and Peter McDougall were entitled to under Clotilde McDougall’s will would have carried obligations to reimburse Bruce McDougall for gift taxes under § 2207A(b), the gifts they made to Bruce McDougall in allowing him to receive all the residuary trust assets should be reduced by their avoided reimbursement obligation.
• The amounts to which Lewis and Peter McDougall would have been entitled under Clotilde McDougall’s will is a question of state law; consequently, the tables prescribed under § 7520 to value remainder interests for federal tax purposes do not determine the value of their gifts to Bruce McDougall.
• In valuing Bruce McDougall’s income interest in the residuary trust, and thus the gifts to Bruce McDougall, his high income alone does not justify departing from standard actuarial tables to determine his life expectancy.
• Considering the conclusions stated above and the IRS concessions, the gifts Lewis and Peter McDougall made to Bruce McDougall had a value of $35,141,321 each.

Conclusion

McDougall and Lewis highlight the complexity of the gift and estate tax framework generally and with respect to valuation of trusts and remainder interests. The cases also emphasize the risks associated with terminating or altering residuary trusts, particularly in the context of taxable estates.

Endnotes
1 McDougall v. Commissioner, 163 T.C. 112 (2024).
2 Lewis v. Commissioner, T.C. Memo 2026-58 (2026).
3 Id. at 3-4.
4 Id. at 4.
5 Id. at 11.
6 Id. at 12.