By Stephan R. Leimberg and Daniel B. Evans
More and more families are “blended families” that include children from a previous marriage (or marriages) of the husband or wife (or both). When federal estate tax planning is needed, the blended family can raise difficult planning issues because a client may want to provide for a less wealthy spouse (and perhaps reduce or defer federal estate taxes), and yet may also want to make sure that any money remaining at the death of the spouse returns to his or her own children—not the spouse’s children.
The QTIP trust allows married clients to “have their cake and eat it, too,” because it can provide an income to the spouse and yet make sure that the wealth remaining upon the death of the spouse is distributed (or held in trust) for the client’s own children, or other beneficiaries selected by the client.
The Terminable Interest Problem
The letters QTIP stand for qualified terminable interest property. A QTIP trust represents an important exception to the general rule that, in order to qualify for the federal estate tax marital deduction, the spouse’s interest in the trust (or other property) must not terminate for any reason. Under this general rule, a life estate does not qualify for the marital deduction, and in most cases, the only kind of interest that satisfies the terminable interest rule is outright ownership.
One traditional exception to the terminable interest rule is the “power of appointment” trust. A power of appointment trust can qualify for the marital deduction if two conditions are met: (1) the surviving spouse must be entitled to all of the income of the trust for life and (2) the surviving spouse must have a “general power of appointment” at death. A “general power of appointment” for this purpose is the power of the surviving spouse to name anyone as the beneficiary of the trust at the spouse’s death, including the spouse’s own estate (so that the trust property could be used to pay the spouse’s debts and then be distributed to the beneficiaries under the spouse’s will).
Previously, planners and their clients were faced with a difficult decision and had only two choices:
Choice 1: In order to qualify for the marital deduction, the client could leave property outright or in a trust that gave the surviving spouse the power to dispose of the client’s property as the surviving spouse wished (which might not be as the client wished).
Choice 2: The client could leave property in a trust that restricted the surviving spouse’s rights and ensured the trust property would ultimately pass (after the spouse’s death) to the client’s own children or to other beneficiaries selected by the client. But this restriction meant trust property would not qualify for the marital deduction. This might result in a federal estate tax liability that could have been deferred or even avoided entirely through the federal estate tax marital deduction.
The federal estate tax marital deduction can be used to avoid estate tax because it allows assets to be shifted from an estate that exceeds the federal estate tax unified credit exemption amount to an estate that is less than the exemption amount.
So, for example, if a widow with a $8 million estate marries a man with a relatively modest estate of $400,000, and if the exemption amount is $3.5 million and the top estate tax rate is 45 percent (which will be the case in the year 2009 under present law), then a marital deduction of $3.1 million would save $1,395,000 in tax because it would allow part of the widow’s estate to be sheltered by the spouse’s unified credit.
Even a deferral of estate tax can be valuable because, if the surviving spouse lives until the year 2010 (when the estate tax is scheduled to be repealed, unless Congress makes a change), the property in the surviving spouse’s estate could entirely avoid the federal estate tax.
So the marital deduction can be valuable, but has traditionally come at the price of losing control of the assets upon the death of the surviving spouse.
QTIP Trust to the Rescue
Fortunately, Congress eliminated the dilemma caused by the terminable interest rule in 1981 by enacting an exception that allows a certain kind of terminable interest property to qualify for the marital deduction. Qualified terminable interest property (QTIP) can qualify for the marital deduction if (a) the surviving spouse is entitled to the income (or use) of the property for life and (b) the executor elects to claim a marital deduction for the income interest. At the death of the surviving spouse, the trust assets are included in the gross estate of the surviving spouse for estate tax purposes, but the surviving spouse does not need to have any power over the property. The first spouse to die can specify who receives the property after the second death. (The probate estate of the surviving spouse is entitled to be reimbursed from the QTIP trust for any additional estate tax caused by the trust.)
A QTIP trust is therefore particularly useful in second marriages because the client can provide for a spouse by putting assets in trust with the income going to the spouse, but can dictate that the assets go to the client’s children, and not the spouse’s children, after the death of the spouse.
A QTIP trust can also add tax-planning flexibility because it does not qualify for the marital deduction until the executor affirmatively elects to claim the deduction, and the executor can still have the discretion as to whether to make the election for all, none or a part of the trust in order to minimize estate taxes. Laws in some states limit executor powers in this regard.
A QTIP trust can also be created during the client’s lifetime instead of at the client’s death, qualifying for the gift tax marital deduction instead of the estate tax marital deduction. This can save estate tax by using the unified credit exemption amount of the spouse to pass assets to the client’s family free of federal estate tax, even if the spouse should predecease the client. And the client does not need to lose the income of the trust if he or she survives the spouse because the client can be a beneficiary of the trust and receive the income for the rest of his or her lifetime.
QTIP Trust Requirements
The QTIP trust must state that all the income of the trust must be paid to the surviving spouse for his or her lifetime, and the following restrictions must be observed:
- No one (not even the surviving spouse) can have the power to distribute any principal from the trust during the spouse’s lifetime to anyone other than the spouse.
- The trust income cannot be terminated by remarriage or any other event.
- The trust income can be paid for the benefit of the spouse (by paying bills directly, for example), but must be paid at least annually and can never be accumulated by the trustees, even if the spouse should become disabled or incompetent.
- The spouse must have the power to require that the trust produce a reasonable income, including the power to require that investments be sold and reinvested so as to produce a reasonable income.
Also, the surviving spouse must be a citizen of the United States. If the surviving spouse is not a citizen of the United States, the normal rules for the marital deduction do not apply (whether outright or in trust). The only way to obtain a marital deduction is through a special form of QTIP trust known as a “qualified domestic trust” (or “QDOT”).
QTIP Trust Options
Many states now allow the grantors of trusts (or the trustees of trusts) to redefine “income” as a fixed percentage of the annual value of the trust. Estate tax regulations now allow such a “total return unitrust” to qualify as a QTIP trust if the unitrust interest qualifies as the “income” of the trust under state law. Redefining trust income to be a unitrust distribution allows the trustees to carry out an investment policy that produces the best long-term yield regardless of whether the yield is ordinary income or capital gain. This guarantees a more predictable income for the surviving spouse and eliminates the possibility of conflict between the surviving spouse and the trustee or other beneficiaries over what is a “reasonable” income for the trust.
Although the surviving spouse does not need to have any power over any of the principal during lifetime or at death, the surviving spouse can be given certain rights or powers over principal if the client wishes.
- The trustee can be given the discretion to distribute principal to the surviving spouse, usually for the health, maintenance and support of the surviving spouse (sometimes with the qualification that the support is to be in accordance with the surviving spouse’s “accustomed standard of living”).
- The surviving spouse can be given the annual noncumulative power to withdraw the greater of $5,000 or 5 percent of the value of the trust.
- The surviving spouse can be given a “special” power to appoint the principal remaining at the death of the surviving spouse among a class of beneficiaries selected by the client. This is usually done when the remaindermen are children of the surviving spouse, and the special power of appointment gives the surviving spouse the power to change the proportionate shares of the children, or add trust provisions for one or more children, if their circumstances should change after the trust is created and before the death of the surviving spouse.
QTIP Trust Obstacles
For blended families, a common stumbling block to adopting a QTIP trust is the basic requirement that the surviving spouse be entitled to all of the trust income for his or her entire life, without qualification. If a client is not willing to agree to that requirement, and insists on provisions regarding remarriage or other contingencies, then the QTIP simply will not work.
Even if the client is willing to provide an income interest in theory, there may be practical problems if the assets passing into the QTIP trust will be undeveloped real estate, a family farm, a vacation home, stock of a closely held business or other assets that produce very little or no income. If the client wishes to preserve those assets for his or her children (or future generations) and the surviving spouse wants, needs and has a right to a reasonable income, then there may be a nearly unsolvable problem.
One possible solution for the client is to purchase additional life insurance through an irrevocable trust. At the client’s death, the trust could provide liquidity for the QTIP trust, either through loans or purchases of assets. A similar solution is to create a family buy-sell agreement for the business or real estate that is fully funded with life insurance owned by the client’s children or other beneficiaries. If the client’s children have the insurance proceeds and the right to buy the business or real estate, then the life insurance proceeds used to purchase the assets can be used to fund the QTIP trust.
Although the QTIP trust imposes some restrictions on the interests that can be given to a surviving spouse, it provides great flexibility in federal estate tax planning, particularly for a blended family that includes children from previous marriages. A client can set up a trust for a spouse, and the trust can qualify for the federal estate tax marital deduction, even though the spouse has no control over the principal of the trust and the remaining principal will return to the client’s family (or other beneficiaries selected by the client) at the death of the spouse.
For more information, please contact Tim Enstice at 757-962-8213 or [email protected].
About the Authors
Stephan R. Leimberg, J.D., is CEO of Leimberg Information Services, Inc. (LISI), an e-mail newsletter and database service for financial services professionals; CEO of Leimberg and LeClair, an estate and financial planning software company; president of Leimberg Associates, a publishing, software and marketing consulting company; and vice president of Leimberg and Leshner, a Web-based data delivery and Web site creation service.
He is the author of many books on estate, financial, and employee benefit and retirement planning and the creator and principal author of the four-book TOOLS AND TECHNIQUES series, including THE TOOLS AND TECHNIQUES OF ESTATE PLANNING.
He is a nationally known speaker on estate planning. Leimberg is frequently quoted in the Wall Street Journal, Forbes, Fortune, Standard and Poor’s’ Outlook, The Christian Science Monitor, Bloomberg’s Financial, Kiplinger’s, and Money magazine.
His Web site, www.leimbergservices.com, is used as a resource by thousands of estate, financial, employee benefit and retirement planning practitioners.
Daniel B. Evans, J.D., received his law degree cum laude from the University of Pennsylvania and practices law in Wyndmoor, Pa., mainly in the areas of estate planning, estate and trust administration, and related tax planning for closely held businesses. He also serves as a consultant to Leimberg & LeClair, Bryn Mawr, Pa., to develop and improve software for lawyers and estate planners.
Dan is a fellow of the American College of Trust and Estate Counsel, is active in the American, Pennsylvania and Philadelphia Bar Associations and has written and spoken extensively on estate planning and legal technology.
He is the author of two books, Wills, Trusts and Technology: An Estate Lawyer’s Guide to Automation (2d Ed.) and How to Build and Manage an Estates Practice, both published jointly by the Real Property, Probate and Trust Law and Law Practice Management Sections of the ABA.
Additional information is available online at: http://evans-legal.com/dan.