By Laurie Israel, Esq., Brookline, MA and Deborah Danger, Esq., Allston, MA
As a lawyer, when consulted about estate planning, a big part of my job is helping people plan for aging, incapacity and where their money goes after they die. Most of this planning revolves around determining how to protect money from taxes and other preventable expenses.
One way to guard against estate tax and ensure wishes are honored is an IRS sanctioned technique called a QTIP trust. This method is often used by those in second marriages with children from a first 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.” I’ll explain these terms.
When is an interest terminable within a QTIP?
A terminable interest ends. For example, a five year lease ends after five years. It is terminable. Another example, a life interest, lasts as long as the person’s life who has the interest. It ends when that person dies. A life interest is considered a “terminable” interest within a QTIP. Oddly, a term less than life, like the five year lease, while “terminable”, does not qualify for QTIP treatment. Let’s see it in action.
How does it normally work?
Being married is the best tax shelter out there. If married at 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 exact value of the property you leave your surviving spouse. It will eventually be taxed, if still owned by your spouse at death. Property you leave to others may be subject to estate tax immediately when you die.
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 $2,000,000 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 death, your surviving spouse can leave your money to whomever he or she wishes, even a subsequent spouse, rather than to your children from your first marriage.
What if instead, to ensure your children get your $2,000,000 legacy, you leave your money to your children? Now, your spouse cannot use the money and it will be diluted by estate tax before your children get it. In 2013, the estate tax is projected to be 55%!
Neither of these scenarios get you where you want to be. This is 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. (Same-sex couples have to wait until DOMA is repealed. Sorry.)
- Your surviving spouse must get at least a life interest in 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.
- 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 will 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 $2,000,000 in a QTIP trust. It can also permit your trustee to arrange for your surviving spouse to get as much of this $2,000,000 as you wish. Then, when your surviving spouse dies, your trustee can give your children the remaining assets.
This arrangement can be put in place at death or during life. If done during life, you can retain a life interest in your $2,000,000. This means you can use your money and the generated income just as you do now. But when you die, the above plan can be implemented.
Why are QTIP Trusts useful?
Besides allowing care for your surviving spouse and ensuring that your children get your remaining principle, QTIP elections can save taxes. Currently, married couples can shelter as much as $10 million dollars from federal estate tax. . But QTIPs are still needed to prior trust provisions for spouses and children.
However, in 2013 (unless the Federal congress makes a law change), the amount married couples can protect against estate tax will reduce to $2 million and be limited to a $1,000,000 exclusion per spouse. Also, the federal estate tax rate will rise to 55%! This will make QTIP planning more important because when one spouse is wealthier than the other a QTIP election will let estate taxable property shift from the wealthier spouse’s estate to that of the less wealthy spouse.
What are partial QTIP elections?
To preserve each spouse’s exclusion, an executor may have to make a partial QTIP election. This will allow allocating the assets between the QTIP trust to benefit the surviving spouse and the estate of the first spouse to die. This split can reduce or even eliminate the total amount of estate tax the couple pays.
Different QTIP elections for state and federal estate tax purposes can also be made if the exclusion amounts for each are different, as they are in Massachusetts and many other states.
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 their principal.
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 the surviving second spouse from getting all the financial care that spouse can get 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 fist spouse to die’s wishes regarding who gets the asset when the surviving spouse dies.
What is the difference between QTIP trust estate planning and Credit Shelter Trust estate planning?
A Credit Shelter Trust can pass part of your estate to a non-spouse beneficiary, such as children, or to a combination of your children and your spouse. Either has the assets administered by a trustee after your death. The value in of the assets in your Credit Shelter Trust is usually dictated by the amount of the federal exclusion and usually is the part of your estate that does not owe any tax.
A Credit Shelter Trust is sometimes called a “family” trust, (because it is for your family) or a “by-pass” trust (because it by-passes federal estate tax your surviving spouse’s would otherwise owe at death). The IRS requires that Credit Shelter Trusts limit the rights of the surviving spouse in order to prevent the Credit Shelter Assets from being included in and taxed from the surviving spouse’s estate.
Once the Credit Shelter Trust is funded to the full amount of the estate tax exclusion, the rest typically goes to the spouse either directly or in a trust, such as a QTIP trust. Once the QTIP election is made for the remaining assets, these assets shift from your estate to your surviving spouse 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.
Has the mystery been solved?
So next time you see the term “QTIP Trust”, don’t be mystified. Just re-read this article. Be forewarned. This type of estate planning should not be done without an attorney. An experienced estate planning attorney in your jurisdiction will help you get this done right and effectively.
© 2012 Laurie Israel and Deborah Danger. All rights reserved.