The Unexpected Tax Consequences of Ending a QTIP Trust Early

Qualified terminable interest property (“QTIP”) trusts are a familiar estate-planning tool.  Under a QTIP trust, a spouse receives the benefit of trust assets during life, with the remainder passing to children or other beneficiaries after the spouse’s death. No transfer tax is payable on the creation of the QTIP trust due to the availability of the marital deduction but the trust assets will be subject to estate tax on the spouse’s death.  But what happens when a family agrees to terminate a QTIP trust during the spouse’s life and transfer the trust assets to the spouse outright?  Is a gift made?  If so, what is the value of the gift? The related cases of McDougall v. Commissioner, 163 T.C. 112 (2024) and Lewis v. Commissioner and McDougall v. Commissioner, T.C. Memo. 2026-58 (July 20, 2026) answered both of those questions. 

The cases involved a QTIP trust created by Clotilde McDougall. Her husband, Bruce, received an income interest while their two children, Linda Lewis and Peter McDougall, held the remainder interests, subject, however to Bruce’s testamentary limited power to appoint the trust principal among Clotilde’s descendants. In 2016, Bruce and the two children agreed to terminate the QTIP trust and distribute its approximately $117.6 million in assets to Bruce outright.

In McDougall, the U.S. Tax Court held that the children made taxable gifts to their father when they surrendered their remainder interests in the QTIP trust, allowing him to receive the trust assets outright.  In Lewis, the Tax Court built on that holding by addressing the next question: what were those surrendered remainder interests worth?

The IRS valued each child’s gift at approximately $53.4 million, while the children argued that their interests were worth only $156,000. The Tax Court ultimately determined that each child made a gift valued at $35,141,321. In reaching that conclusion, the Court rejected the children’s argument that Bruce’s potential exercise of his limited testamentary power of appointment severely reduced the value of their interests, which the Court determined had to be valued based on their actual rights under the trust instrument and Washington state law. The Court also rejected the IRS’s argument that IRC § 7520 — which provides actuarial tables for valuing life estates, term interests and remainder interests for gift- and estate-tax purposes — controlled here because the children’s entitlements to the trust property on a termination of the trust had to be determined under state law. Finally, the Court agreed with the children that their gift to Bruce had to be offset by Bruce’s right under IRC § 2207A(b) to recover gift tax on his own deemed gift to them of the remainder interests under IRC § 2519.

For anyone considering an early termination of a trust, Lewis/McDougall presents gift tax consequences that must not be overlooked. The case is a reminder that when an estate plan is modified, it is important to understand not only what assets are being transferred, but what rights are being given up in the process and how those rights will be valued under applicable state and federal tax law.