By Laurie Israel, Esq., Brookline, MA and Deborah Danger, Esq., Allston, MA
A big part of my job as an estate planning lawyer is helping people plan for where their money goes after they die. Much of this planning revolves around determining how to minimize estate taxes, and yet get the money to those people who are my clients’ loved ones in the most beneficial way. In this article, we will focus on Federal and Massachusetts law; many other states have estate tax laws similar to those of Massachusetts.
One way to eliminate or defer estate taxes and ensure wishes are honored is an IRS sanctioned technique called a QTIP trust. A QTIP trust estate plan is very helpful in reducing or eliminating estate taxes. Also, this method is helpful in balancing needs of a surviving spouse with final distributions to children, including children of a prior marriage.
What is a “QTIP” trust?
While many have heard the term QTIP trust, its definition is a mystery to most. In general, a trust is an arrangement that transfers asset ownership from an individual to a trustee charged with protecting and using the assets for others. A QTIP trust is a special kind of trust.
What does “QTIP” stand for?
QTIP stands for “Qualified Terminable Interest Property.” We’ll explain these terms.
When is an interest terminable within a QTIP?
Estate tax law allows for a deduction from the total assets of an estate for assets passing to a surviving spouse. Generally those assets will be passed to a spouse outright, without a trust, and doesn’t allow a deduction if the assets eventually go to another beneficiary.
However, estate tax law has made an exception to this rule. It allows for the marital deduction for a trust that lasts for a spouse’s life, but where the assets left over, can go to other persons. This is done by means of a QTIP trust – the surviving spouse has a terminable interest, but it’s a “qualified” terminal interest, where the surviving spouse as adequate rights as set forth in the Internal Revenue Code. In a QTIP trust, generally the assets left over go either to the children of the marriage, or children of the decedent’s prior marriage, but can go to anyone. But the trust for the surviving spouse has to meet certain to qualify for favorable estate tax treatment.
How does the QTIP Trust normally work?
Being married is the best tax shelter out there. If you are married at your death, property left to your surviving spouse will not generate estate tax. This is because the tax code permits your estate a marital deduction for the total value of the property you leave your surviving spouse. In addition, that property will get a “step-up” in basis to fair market value at the time of your death. As a result, if your surviving spouse sells it immediately, there will be no capital gain, even if your purchase price (basis) for the property was much less. If your surviving spouse owns it at her death, it will be in her estate tax gross estate, and she may owe estate tax if her estate is large enough. Basically you are “bunching up” your estate and hers, and maybe triggering estate tax at the death of the last of you to die. (But see portability discussion below.) Let’s say you have children from a first marriage. You are in a second marriage. You die before your second spouse and your only asset is a $6 million savings account. If you leave the money to your surviving spouse, your estate won’t owe any tax. The marital deduction will defer it until your spouse dies.
But at the surviving spouse’s death, your surviving spouse can leave your money to whomever he or she wishes. If a second marriage, the surviving spouse could leave the assets inherited from you from children of his or her prior marriage rather than to your children from a prior marriage.
What if instead, to ensure your children get your $6 million legacy, you leave your money to your children? Now, your spouse cannot use the money and it will be diluted by Federal and Massachusetts estate tax before your children get it.
Neither of these scenarios gets you where you want to be. That’s where a QTIP trust comes in.
What does the “qualified” in QTIP mean?
To qualify and get QTIP treatment, the QTIP rules need to be followed carefully.
- You must be in a federally recognized marriage. This now includes same-sex couples who have legal married anywhere in the U.S.
- Your surviving spouse must get at least a life interest in all of the trust’s income and it must be distributed at least annually. You can also let your trustee use the trust assets to care for your spouse up to a defined standard of living like to maintain health and education. (Your surviving spouse can even be the trustee of the QTIP trust containing this distribution plan.)
- You must authorize your executor to elect QTIP treatment and the election must be made.
- Your surviving spouse must be the only lifetime beneficiary of your trust assets until your surviving spouse dies.
- Your spouse must be a U.S. citizen.
What kind of property qualifies for QTIP treatment?
Almost all property in a trust to benefit your spouse can qualify for QTIP treatment.
What happens when you elect QTIP treatment?
Consider these QTIP trust features:
- It preserves the unlimited marital deduction between spouses, takes full advantage of the credit shelter exclusions, and postpones estate tax until the surviving spouse dies.
- It allows the trust assets to be used to care for the surviving spouse.
- It allows the first spouse that dies to control where the trust’s assets go when the surviving spouse dies. In a second marriage, this may be to the first marriage’s children.
How does QTIP treatment work?
A QTIP trust expands marriages’ estate tax benefits. Your will can gives your executor the power to put your $6,000,000 in a QTIP trust. It can also permit your trustee to arrange for your surviving spouse to be the beneficiary of the income of as much of this $6,000,000 as you wish, if you don’t want the entire property to qualify for QTIP treatment. Then, when your surviving spouse dies, your trustee can give your children the remaining assets.
Why are QTIP Trusts useful?
Besides allowing care for your surviving spouse and ensuring that your children get your remaining principal of the trust, QTIP elections can save Federal and state estate taxes. Currently, a person can die with $5.43 million and not owe any Federal estate taxes. Let’s say you have $6 million in your estate and you transfer your entire estate to your surviving spouse who has her own assets. A very large Federal estate tax will be due at her death, which at present rates, would be 40% of the excess over $5.43 million of both her and your property, which might grow by the time of her death. By putting $5.43 million into a QTIP trust for your spouse’s benefit, the first to die of the spouses can fully utilize his Federal estate tax credit shelter.
With respect to Massachusetts estate tax, Massachusetts imposes an estate tax for estates of over $1 million. If the $1 million is transferred to the surviving spouse, no tax is due at the first death, but an additional significant tax is due at the second death. This tax can be reduced or eliminated by putting $1 million into a QTIP trust which is elected for Massachusetts estate tax purposes. This will utilize the credit shelter of the first-to-die of the spouses.
What is a partial QTIP election?
To preserve each spouse’s Federal and/or Massachusetts estate tax credits, an executor may have to make a partial QTIP elections, and also make different QTIP elections for Federal and Massachusetts estate tax purposes. This can help eliminate, reduce or defer estate taxes.
What are the disadvantages of QTIP treatment?
Differing opinions about investment and tax strategies for the QTIP trust assets may create conflict between the surviving spouse and the children. The surviving spouse may encourage strategies that maximize income while children wish to conservatively preserve the principal that they will receive in the future. Or the children may want to create capital gains in the principal which may not generate current income.
Some children express a preference to pay estate taxes at their parent’s death in order to get immediate access to their inheritance. But this prevents a surviving second spouse from getting all the financial care that spouse may need as she (or he) ages.
The surviving spouse typically resents the restrictions against unlimited access to principal. However, they are necessary to prevent circumventing the first spouse to die’s wishes regarding who gets the asset when the surviving spouse dies. In addition, the restrictions are necessary in order to preserve QTIP tax treatment that funds the credit shelters of the first spouse to die.
What is the difference between QTIP trust estate planning and Credit Shelter Trust estate planning?
Credit Shelter Trust planning generally involves a Credit Shelter Trust and one or more Marital Deduction trusts. The funds in a Credit Shelter Trust are the part of the estate which is estate-tax free. Therefore, it can passed to your spouse, or non-spouse beneficiaries, or both. The assets are in trust, and therefore administered by a trustee after your death. The trustee may be directed to pay the proceeds directly to the beneficiaries and terminate the trust.
A Credit Shelter Trust is sometimes called a “family” trust, because it can be for your family, which includes spouse and children. It’s also called a “by-pass” trust because it by-passes federal and/or Massachusetts estate tax that your surviving spouse’s would otherwise owe at death. The IRS requires that Credit Shelter Trusts limit the rights of the surviving spouse and other beneficiaries in order to prevent the Credit Shelter assets from being included in and taxed from the surviving spouse’s or the other beneficiaries’ estates upon their death. The main prohibition is that the beneficiary’s rights do not rise to the level of a general power of appointment, where they can pay themselves all or part of the funds without restriction.
Once the Credit Shelter Trust is funded with the full amount of the estate tax exclusion, the rest typically goes to the spouse either directly or in a marital deduction trust, with QTIP provisions. Once the QTIP election is made for the remaining assets, these assets shift from your estate to your surviving spouse’s estate and are taxed at the death of your surviving spouse and can be used to benefit your spouse and your children as you dictate within the QTIP requirements.
Because in many cases, the surviving spouse has fewer assets than the decedent husband, it is a way to fully use both the husband’s credit shelters and the surviving spouse’s.
Portability – A New Tax Law.
Because not everyone sets up estate planning trusts prior to their death and because often not both spouses have assets in their names, in 2010, Congress enacted a law which provides a way to utilize the Federal credit shelter of a decedent spouse who has not set up trusts.
If your spouse dies, and she does not have enough assets to use the Federal credit shelter, you may elect to “port” her unused exclusion amount (DSUE)to your eventual estate tax return. You would make the election by having her executor or personal representative timely filing a form 706 Federal Estate Tax Return for her, whereby portability is elected. In order to make the election, the Federal estate tax return must be filed, even if it would not otherwise have been required to be filed. Say the decedent wife’s ’s estate is$2 million. That amount does not require the filing of a Federal estate tax return. ). If portability is elected, the surviving spouse’s estate will have the benefit of the decedent wife’s Federal exclusion amount, plus the unused exclusion amount of the husband when he eventually dies. So he would have the benefit of an additional Federal exclusion of $3.43 million ($5.43 million, the current exclusion amount, less $2 million in the wife’s).
A major downside of using portability is that if credit shelter property is put into a trust, when the trust terminates, all the gain on the property in the trust from the time of the first death goes to the beneficiaries without another layer of estate tax on the gain that might have accrued between the two deaths. The portability amount is a flat amount (maximum in 2015 is $5.43 million), which goes up by indexing, but will not reflect the potential (and hoped for) gain or increase of the property when invested.
Another problem is in the event the surviving spouse has remarried, she is limited to the DSUE the most recent spouse and any excess credit shelter “saving” from the prior spouse is lost. A third problem is that Massachusetts has not enacted a portability statute, and hence the Massachusetts exemption cannot be “ported” to the surviving spouse.
QTIPs demystified. So next time you see the term “QTIP Trust”, you may have a better understanding of what this term entails. Be forewarned. This type of estate planning should be done with an attorney. An experienced estate planning attorney in your jurisdiction will help you get this done right and effectively.
© 2012 and 2016 Laurie Israel and Deborah Danger. All rights reserved.
Laurie Israel is an attorney and mediator practicing in Brookline, Massachusetts. She concentrates her practice on estate planning, probate of estates, tax law, divorce, mediation, and prenuptial agreements. Laurie’s website is www.ivkdlaw.com
Deborah Danger is an attorney practicing in Newton, Massachusetts. She concentrates her practice on divorce law, estate planning, probate and post death administration of estates, including preparation of the associated tax returns. Deborah’s website is www.dangerlaw.com