There are deductions from Federal Estate and Gift taxes, and this article deals with certain aspects of the “marital deduction”. The marital deduction is permitted for property given to a surviving spouse outright, or through a qualifying QTIP trust. The marital deduction is available without the use of a QTIP trust, through outright bequests, holding title in joint tenancy, general power of appointment trusts and estate trusts, but the marital deduction for QTIPs is available only if the executor of the decedent’s estate elects such treatment, by listing QTIP property in Schedule M of the Form 706.
Why use a QTIP trust?
There are several reasons for using a QTIP trust.
- Control Issue Eliminated. Where the estate owner wants to control where the trust corpus is to be distributed, when the surviving spouse dies, he or she can do so with a QTIP trust. If the surviving spouse remarries, he or she will receive lifetime income, but will have no control over the trust corpus upon death. By using a QTIP trust, the estate owner insures that his or her share of property and any separately owned property will not be diverted to beneficiaries who are not intended heirs.
Thus, the surviving spouse enjoys the income from the property during her life, but does not control disposition of the trust property itself (other than the income). The creator of the QTIP trust specifies the residual beneficiaries, but does not jeopardize use of the marital deduction. If the surviving spouse later remarries, her children cannot be disinherited under the QTIP trust.
- Power to invade may be given to trustee or others. In addition to giving the surviving spouse the income from the QTIP trust, a limited or unlimited power to invade trust principal for the spouse’s benefit may be given to a trustee other than the spouse or to persons other than the trustee.
- Special power of appointment permitted after death of surviving spouse. The surviving spouse may be given a limited testamentary power (a special power of appointment) to appoint trust principal, to a class of persons, such as children, grandchildren, nephews, nieces issue, etc.
- General power of appointment permitted after death of surviving spouse. If the surviving spouse is given a general (unlimited) testamentary power of appointment over trust principal, the trust would qualify for the marital deduction as a life estate-power of appointment trust.
- Miscellaneous. In addition to the benefits mentioned, here are some additional factors to consider:
- The Executor can choose the most advantageous marital deduction by electing the marital deduction for less than all of the property in the trust. This advantage can best be understood by contrasting two approaches: Suppose H and W own stock in a closely held corporation. H dies first, and W inherits H’s stock, through a marital deduction trust, and W receives income for life, with a general power of appointment to W. This arrangement qualifies for the marital deduction, but W’s stock will be aggregated, for valuation purposes, with the stock she owns outright. Bonner, Louis Sr. Est v. U.S., (1996, CA5) 77 AFTR 2d 96-2369, 84 F3d 196, 96-2 USTC 60237. If a QTIP trust is created, for the A-portion of the trust, the Executor can elect to treat part, but not all, of the property as marital deduction property. If H’s stock is allotted to a QTIP trust for W’s benefit, the stock does not have to be valued as a controlling interest in the corporation. Fontana, Aldo H. Est, (2002) 118 TC No. 16.
- Use of a QTIP trust can save generation-skipping transfer (GST) taxes, through a “reverse QTIP” election. The reverse QTIP election to treat the first spouse to die as the transferor for GST tax purposes can be made only if a QTIP trust is used. This benefit will be covered in another section of the outline.
- When the estate taxes are repealed (year 2010), the spousal basis adjustment for purposes of the carryover basis rules can be augmented in a QTIP trust. Sec. 501, 531, 532, 901 PL 107-16, 6/7/2001. A QTIP trust permits allocation of $3 million spousal basis adjustment under carryover basis rules in 2010. The carryover basis rules generally provide that assets received from a decedent are the same basis in the hands of the recipient. The decedent’s executor will, however, be able to allocate $1.3 million of additional basis to assets (regardless of to whom they pass), and $3 million of basis to assets passing to the decedent’s surviving spouse, either outright or to a qualified terminable interest property (‘QTIP’) trust. Sec. 542(a) PL 107-16, 6/7/2001; Code Sec. 1022(c). This is known as the spousal property adjustment, which can increase the basis of assets received from a decedent, but not beyond their fair market value on the date of death.
- The marital deduction of a QTIP trust can be defined by a fraction or percentage formula. Formula elections help where the exact amount of marital deduction needed to produce the best tax result cannot be determined at the time the election must irrevocably be made. For example, if the election decision was based on the value of the estate as originally reported on the estate tax return, a change in that value, as the result of an audit completed after the time to make the election had expired, would leave the executor in a difficult situation. In order to avoid this problem, the executor can, on the decedent’s estate tax return, elect the marital deduction for that fraction (or percentage) of the estate which will reduce the federal estate tax owed to the lowest possible amount (including zero). Another type of formula would be an ‘equalization’ formula designed to equalize the estates of two spouses who have died simultaneously or within a short time of one another. This type of formula QTIP election could be very useful when, at the time the election must be made in the estate of the first spouse to die, the value and composition of the surviving spouse’s estate has not been completely determined.
What is a QTIP trust?
A QTIP trust is (a) a trust (b) under which the surviving spouse is entitled to all the income for life and (c) no person can appoint any part of the property to anyone other than the surviving spouse during his or her life.
Each of these elements is critical. The surviving spouse must be entitled to all of the income from the trust corpus during his or her entire life. Anything less will disqualify the trust for marital deduction purposes. For example, the following trust provisions disqualify the trust for marital deduction purposes:
- A trust which pays the spouse income for a term of years (even though that period exceeds her life expectancy).
- If the survivor’s income rights are curtailed if he or she remarries
- If the trust income may be sprinkled among a class of beneficiaries, which includes the spouse and others
- Power to accumulate all or part of the trust income, even though all income will be payable to the surviving spouse prior to death.
- Power to withhold income from the spouse in the event of remarriage.
- Power to appoint trust corpus to any person other than the surviving spouse (however, if the principal may be appointed to non-spouse beneficiaries, after the surviving spouse’s death, the trust will qualify for marital deduction purposes).
- Power of the surviving spouse during her lifetime to appoint principal to her children, issue, descendants, etc.
- Power of the trustee to invade principal during the spouse’s lifetime for benefit of persons other than the surviving spouse.
In addition to these “disqualifying” powers, there are certain types of property which cannot be placed in a QTIP trust. For example, if non-income producing real estate is placed in the QTIP, the QTIP criteria is not satisfied. If the spouse has the right to direct that the non-income producing property be sold and converted to income producing property, then the QTIP criteria is satisfied. Reg § 20.2056(b)-5(f)(4); Reg § 20.2056(b)-7(d)(2). As a practical matter, the trustee is normally permitted to sell and re-invest trust property, and such a trust provision will normally protect the QTIP’s eligibility for the marital deduction; the surviving spouse would have to consent to the QTIP holding unproductive property for an unreasonable time.
Here are some powers which do not disqualify the trust for the marital deduction (stated differently, a trust will qualify for the marital deduction if the following powers are present):
- The surviving spouse may appoint principal to herself (including a power invasion solely for her own benefit), even though such a power permits the surviving spouse to make tax-free gifts (within the annual exclusion) to other persons and avoid estate tax in her estate on the amounts given away.
- A limited or unlimited power to invade trust principal for the spouse’s benefit may be given to a trustee other than the spouse or to persons other than the trustee.
- The executor’s power to elect all or a fractional/percentage portion of the QTIP trust property to qualify for the marital deduction. The decision as to the amount of property to qualify for the marital deduction may be postponed until after the spouse’s death at a time when financial resources and needs may be more clear.
If the QTIP requirements are met, certain property not in trust, such as life insurance proceeds and a joint and survivor annuity, can qualify under the QTIP rules for the marital deduction.
QTIP Trusts Used In Conjunction with Other Trusts
Only part of the decedent’s trust assets need be placed in a QTIP trust. In a second marriage situation which lasts for some time, the surviving spouse might want the power to appoint part of the martial assets to designated beneficiaries. The remainder of the martial assets might be placed in a QTIP trust, over which the decedent Settlor demands the right to designate the ultimate beneficiaries.
QTIP Trust Compared with Estate Trust
The ‘estate trust’ under which the surviving spouse is the income beneficiary with the remainder payable to the surviving spouse’s estate has traditionally been used to qualify property for the marital deduction where it was desirable to provide for accumulation of income by the trustee rather than paying income out annually to the surviving spouse. This has permitted all or part of the income to be accumulated and taxed to the trust rather than to the surviving spouse. An estate trust also permits retention in the trust of unproductive property.
In a QTIP trust, income may not be accumulated and unproductive property may not be retained without the surviving spouse’s consent.
Under the estate trust, the marital deduction will be obtained automatically for the estate owner’s estate, without satisfying the requirement that the executor elect to treat property as QTIP property.
Checklist for QTIP trusts
If an estate owner’s will provides for a QTIP trust for his surviving spouse, several additional provisions should be considered for inclusion in his will. These are:
- Factors to be considered by executor in making election decision
- Provision for payment of estate tax on QTIP trust included in surviving spouse’s estate. QTIP trust property for which a marital deduction election was made is included in the gross estate of the surviving spouse at her death, IRC Sec. 2044(a), provided she made no prior disposition of all or part of her income interest. Code Sec. 2044(b)(2). However, the surviving spouse’s estate is entitled to recover the estate tax on the QTIP trust property from the recipients of the trust property (e.g., the remaindermen). Code Sec. 2207A(a). To insure that the surviving spouse’s estate will receive estate tax and other death taxes on the QTIP trust property prior to distribution of the QTIP trust property to the remaindermen, it may be desirable to incorporate into the estate owner’s will a provision requiring the trustee of the QTIP trust to pay to the executor of the surviving spouse’s estate an amount equal to the death taxes caused by inclusion of the QTIP trust property in the surviving spouse’s estate, before the remainder is distributed to the designated recipients.
- Restriction on power of executor or trustee to retain unproductive property in QTIP trust
- Authorization to create separate QTIP trust when reverse QTIP election is made.
There are many secret and dark alleys contained in the Internal Revenue Code, and dragons and goblins lie in wait to ambush grandchildren with generation skipping transfer taxes. Since it is not unusual for grandparents to provide for their grandchildren, especially if the grandparents are loaded, the issue becomes, how do we avoid incurring the generation skipping transfer tax (please review portions of the article containing an explanation of the GST before proceeding with this analysis)?
In a normal estate plan, lawyers and accountants usually think no further than the creation of an A/B tax sheltered trust, with the thought that such action is about all that can be done for those with estates of about $2 million. In some instances, however, the A trust, which could be in the form of a QTIP trust, and the B-trust, which is in the form of a by-pass trust, will name grandchildren as the residual beneficiaries (the parents are either angry with their children, or their children don’t need the money). If that is the case, the following example will illustrate the estate tax consequences. I am using 2002 tax rates.
No reverse QTIP
|B Trust||$ 1,000,000.00|
|QTIP||$ 1,000,000.00||$ 1,000,000.00|
There are no estate taxes on Wife’s death, because the QTIP trust is available at W’s death, and her husband will continue to use and enjoy the income from the B trust, or by-pass trust (which is taxed, but the unified credit nets out any tax due). When H dies, his independent estate is worth $1,000,000, which means, the taxable estate is $2,000,000 (his estate, plus the QTIP trust), so the estate taxes total $435,000. However, since his children are still alive, and since H & W leave their residual estates to their grandchildren, the GST is an additional $950,000. For purposes of the GST, the total assets include H’s entire taxable estate and W’s bypass trust. Granted, the grandkids will benefit from the GST exclusion of $1,100,000, but they will still be taxed at 50% of the difference between $3,000,000 and $1,100,000, or $950,000 (50% x $1,900,000 = $950,000).
At this point, one may rightfully ask, why wasn’t the GST exclusion doubled, as it was in the A/B trust? The reason is the design of the Internal Revenue Code. To “double” the GST exclusion, for both husband and wife, a technique using a reverse QTIP must be used. The trustee is permitted and directed, as circumstances so warrant, to divide the QTIP trust into sub-trusts. One sub-trust will require an special election under Schedule R on the Federal Estate Tax Return, when W dies. The surviving spouse still receives income, as required under the QTIP rules, but the residual beneficiaries, who are grandchildren, will enjoy a second GST exclusion. In other words, the surviving spouse will not be regarded as inheriting all of the QTIP trust, for purposes of the GST exclusion.
The special election under Code Secs. 2652(a)(1) to treat the first spouse as the transferor for GST tax purposes (reverse QTIP election) can be made only with respect to a QTIP trust. Reg § 26.2652-2(a) ; Peterson Marital Trust, E. Norman, (1994) 102 TC 790, affd on other issue (1996, CA2) 77 AFTR 2d 96-1184, 78 F3d 795, 96-1 USTC 60225. Thus, the first spouse’s GST exemption can be allocated to a reverse QTIP trust, whereas it cannot be effectively allocated to other kinds of marital deduction transfers.
Here’s the illustration of what we’re talking about:
|$0 is the||($1,100,000/$1,000,000)|
|subject to GST||times 55% times 0|
Now let’s see what happens to H’s estate, which for purposes of the GST tax, consists of his own assets of $1,000,000 and the B-trust assets from W’s estate:
|$1100000 is the||($1,100,000/$2,000,000)|
|subject to GST||times 50%|
|Federal Est. Tax||$ 435,.000.00|
|Total GST and ET||$ 885,000.00|
Here is a summary of what using the reverse-QTIP can do:
|Total estate and GST taxes||$ 885,000.00|
As you can see, by using the reverse Q-tip technique, close to $500,000 in taxes is saved, which amounts to approximately 18% of both estates (without the reverse QTIP, the total taxes are $1,385,000, consisting of $435,000 estate taxes and $950,000 GST taxes).
If the sunset provisions of EGTRRA become effective and the estate tax is restored in 2011, the prior rule on division of trusts for GST tax purposes would be restored. Sec. 562, 901 PL 107-16, 6/7/2001.
Now let’s go into some guidelines.
First, the trust should authorize splitting the QTIP trust. One QTIP trust can hold the exact amount of the unused GST exemption (‘the reverse QTIP trust’) and a second QTIP trust takes the balance of the QTIP bequest. Because the unified credit exemption increases between now and 2009, the importance of the reverse QTIP election will be less as time goes by. However, in 2011, we return to the 2001 tax rates, and reverse QTIPs will be important again.
Second, if the will or living trust agreement uses a reverse QTIP trust formula clause and if the balance of the estate does not pass to the surviving spouse in a form that will qualify for the marital deduction, the governing instrument should mandate how the GST exemption is to be allocated. The fiduciary should not be given any discretion to allocate the GST exemption
Third, the fiduciary will make a special election under Code Secs. 2652(a)(3) to treat the trust for GST tax purposes as if the estate tax QTIP election had not been made (the ‘reverse QTIP election’). When a reverse QTIP election is made with respect to a trust, the identity of the transferor is determined, solely for GST tax purposes, without regard to the application of Code Secs. 2044, Code Secs. 2207A, and Code Secs. 2519. Code Sec. 2044 ; Code Sec. 2519. Reg § 26.2652-1(a)(3). This means that the transferor’s surviving spouse doesn’t become the transferor for GST tax purposes at the surviving spouse’s later death even though the trust is included, under Code Secs. 2044, in the surviving spouse’s gross estate for estate tax purposes. Because the predeceased spouse remains the transferor for GST tax purposes, the fiduciary can effectively allocate the predeceased spouse’s GST exemption to the reverse QTIP trust.
Fourth, avoid having fiduciary make reverse QTIP election for entire QTIP trust if trust’s value exceeds unused portion of GST exemption.
Fifth, permit the fiduciary to allocate the GST exemption to both lifetime transfers and transfers occurring at death. The fiduciary should also be given the discretion to treat beneficiaries differently, and the fiduciary should be exonerated from liability for all decisions made in good faith and without gross negligence. Any portion of a decedent’s GST exemption that has not been allocated to lifetime transfers or by the fiduciary of his will or living trust agreement by the due date of his estate tax return will be automatically allocated in a prescribed way. Code Sec. 2632(c)(2); Reg § 26.2632-1(d)(2). Because statutory allocation may not produce the best GST tax results, the governing instrument should alert the fiduciary that he should allocate the GST exemption whenever statutory allocation would not be appropriate.
Sixth, where there is a direction in the governing instrument to create a separate reverse qualified terminable interest property (QTIP) trust, the value of the reverse QTIP trust should not be fixed in the will or living trust agreement at a stated dollar amount (such as $400,000), especially in light of the fact that the unified credit is increasing until 2009 and GST exemption is being adjusted for inflation through 2003 and then increasing on the same schedule as the unified credit. Rather, a formula should define the amount of the bequest passing to the reverse QTIP trust. The amount of the bequest should equal the testator’s remaining generation-skipping transfer (GST) exemption, after taking into account:
- allocations made by the testator to lifetime transfers;
- allocations deemed to have been made by the testator to lifetime transfers;
- allocations made by the fiduciary to lifetime transfers; and
- allocations made by the fiduciary to other transfers occurring at death.
The advantage of using a formula is that the formula adjusts for allocations of the GST exemption to:
- transfers that occur before the governing instrument is drafted where the client is unaware of the GST tax consequences (e.g., a direct skip to which GST exemption was automatically allocated);
- transfers that occur after the governing instrument is drafted and that cannot be anticipated (e.g., future gifts); and
- expected future transfers of indeterminate amounts (e.g., the bequest to the credit shelter trust, the value of which will be reduced by gifts in excess of the annual exclusion amount and by state death taxes and nondeductible items charged to it).
GST Traps and Psychological Issues. Most estate plans provide for the surviving spouse and children, but not to remote issue. In many instances, the trust for the children will continue until the children reach an age when they are mature enough to handle significant amounts of property. For example, a provision that a child’s trust terminates when the child reaches age 30 or 35 is common. If the child dies during the term of such a trust and his share passes to his children, this will be treated as a generation-skipping transfer for GST tax purposes.
The client may be concerned about delegating so much authority to the fiduciary (for example, when the second spouse will be acting as fiduciary and allocations will affect transfers to issue of a first marriage). The client may prefer instead to direct the fiduciary to allocate GST exemption in a specified manner. The disadvantage of this approach is that the fiduciary has no flexibility to adjust for circumstances that have changed since the drafting of the will or living trust agreement. A possible compromise approach is to name an independent fiduciary and give him discretion with some suggested guidelines.
If the clients want the marital share to pass, upon the surviving spouse’s death, outright to their children or in a trust that will be includible in the children’s estates (or outright to, or in an estate-includible trust for, grandchildren when the grandchildren’s interest is in representation of a predeceased parent), then there will be no reason to use the reverse QTIP election. And if the clients are willing to pay some upfront estate tax (i.e., upon the first spouse’s death), then a GST exemption trust can be used (rather than a credit shelter trust).
If the governing instrument contains no direction or authorization to create a separate reverse QTIP trust, the fiduciary would be able to create a separate trust that will be respected for GST tax purposes only if a state statute or a state court authorizes the fiduciary to divide the QTIP trust into two trusts. But don’t rely on a state statute to solve the problem because the client’s domicile may not be the same at the time of his death. And don’t rely on a state court to rewrite the will or living trust agreement because a reformation proceeding will result in extra costs and cause delay in estate administration.
A married couple must decide whether the surviving spouse is willing to relinquish complete control over assets to save GST taxes for issue. A husband and wife face the same choice when deciding whether to give all property outright to the surviving spouse, or instead to hold the credit equivalent amount in trust so that the property is sheltered from estate taxes at the surviving spouse’s death.
Some couples want to postpone making a decision about a credit shelter trust until the death of the first spouse so that the surviving spouse can take into account the circumstances at that time and his or her feelings about having such a trust. Similarly, a couple may want to keep the option of a reverse QTIP trust open. Also, with the amount of the unified credit increasing until 2006, postponing the decision about the credit shelter trust and reverse QTIP trust can allow for a decision based on the most current tax picture at the date of the first spouse’s death. This postponement can be accomplished by providing in the will or living trust agreement that if the surviving spouse disclaims a portion (which will be equal in amount to the first spouse’s remaining GST exemption) of an outright bequest, the disclaimed property will pass to a QTIP trust.
While the surviving spouse controls whether a trust will be created when a disclaimer reverse QTIP trust is used, she is not permitted to change the disposition of such a trust through the exercise of a power of appointment. Code Sec. 2518(b)(4) ; Reg § 25.2518-2(e)(2) ; Reg § 25.2518-2(e)(5), Ex (5).
If a trust included in the transferor’s gross estate or created under the transferor’s will is severed under a direction in the governing instrument, it will be treated as a separate trust for GST tax purposes. Reg § 26.2654-1(b)(1)(i) ; Reg § 26.2654-1(b)(3).
Thoughts About Inclusion Ratios: It is important to understand the inclusion ratio. The numerator of the applicable fraction is the amount of GST exemption allocated to the trust. Code Sec. 2642(a)(2)(A). The inclusion ratio of the trust equals one minus the applicable fraction. Code Sec. 2642(a)(1). Producing a GST inclusion ratio of zero for a trust intended to be GST-protected is the most important objective. For this reason, it’s important to satisfy all of the separate trust requirements so that only that amount of the GST exemption equal to the reverse QTIP trust need be allocated to produce an applicable fraction with a numerator equal to the denominator (1 -1/1 = 0).
Now that you understand the mechanics of computing the inclusion ration, keep in mind that a reverse QTIP trust with an inclusion ratio between zero and one is undesirable for the following reasons:
- The surviving spouse’s GST exemption cannot be allocated to the reverse QTIP trust because the first spouse to die remains the transferor of the trust for GST tax purposes. Reg § 26.2652-1(a)(6), Ex (6). Thus, the surviving spouse’s GST exemption will be wasted if she does not have sufficient assets of her own to which the surviving spouse’s GST exemption can be allocated.
- Any transfer from the reverse QTIP trust to skip persons occurring at the surviving spouse’s death is treated as a taxable termination, not a direct skip. Reg § 26.2652-2(d), Ex (1) ; Rev Rul 92-26, 1992-1 CB 314. The GST tax is computed on a ‘tax-inclusive’ basis with respect to taxable terminations, which means that the taxable amount includes the GST tax. Genl Expl of Tax Reform Act of ’86, Pl 99-514, 5/4/87, p. 1266.
- Part of the GST exemption is wasted if the reverse QTIP trust is reduced by–
- principal distributions, or
- death taxes.
- The ‘predeceased parent rule’ is not available at the death of the transferor’s spouse to ‘move’ the grandchildren of the transferor up one generation level if their parent dies during the term of the reverse QTIP trust and they take in representation of their deceased parent. Rev Rul 92-26, 1992-1 CB 314.
The fiduciary should be required to fund the reverse QTIP trust in accordance with the GST regulations . This will ensure that:
- only the reverse QTIP trust’s value (and not the combined value of the reverse and ‘regular’ QTIP trusts) will be included in the denominator of the applicable fraction, because the reverse QTIP trust is respected as a separate trust for GST tax purposes (the separate trust rules ); and
- federal estate tax values, rather than date of distribution values, may be used in the denominator of the trust’s applicable fraction (the valuation rules ).
© 2002 James H. Beauchamp