New Estate Planning Value In QTIP Trusts

The venerable qtip trust is an even more valuable estate planning tool for married couples after the 2001 tax law.  Traditionally, the QTIP could save heirs a bundle of money while ensuring that wealth is distributed as you intended. But the trust can give your estate planning additional flexibility that is a key to dealing with the shifting tax law we face over the next 10 years.

In a qualified terminable interest property (QTIP) trust, property is placed in a trust for the benefit of a surviving spouse for his or her life. After that spouse’s death, the property remaining in the trust goes to other heirs designated by the trust’s creator, who usually are the children of the marriage.

The QTIP is the only way to qualify property for the marital deduction, thereby eliminating estate taxes, without giving the surviving spouse complete control of the property. To ensure that all the property going into the trust qualifies for the marital deduction, the surviving spouse must have the right to all income from the trust, and that income must be paid at least annually.

In addition, you can allow trust principal to be disbursed to the surviving spouse when needed for health, maintenance, education or other defined purposes. The surviving spouse can be the trustee who decides when to make such payments.

When the second spouse dies, that estate is taxed on the property remaining in the trust. The trust property can be used to pay those estate taxes before the rest goes to the other heirs.

The traditional advantage of the QTIP trust is that the first spouse to die is able to provide for the surviving spouse while controlling who eventually gets the property. The QTIP ensures that the wealth does not go to a new spouse or the children of another marriage. The QTIP also ensures that the property is not taxed in the first estate. The second spouse has to do the estate planning or accept that the property will be by taxed after his or her death.

The new advantage of the QTIP trust is its flexibility. You can state in your will exactly how much property will be in the trust. But an alternative is to give the trustee discretion to decide how much of your estate goes into the QTIP. The decision doesn’t have to be made until the estate tax return is due to be filed, including extensions. That gives the executor up to 15 months to decide (the original nine month deadline plus a possible six month extension.)

In the quarterly special report for August 2001 I discussed the shifting amount that can be left tax-free to heirs over the next 10 years. Last month I explained the estate planning pitfalls this can lead to. Formulas in the will need to be frequently revised or carefully drafted to avoid either not taking maximum advantage of the exemption or leaving too little to the surviving spouse. Another way to avoid these pitfalls is to depend on the surviving spouse to disclaim part of the inheritance to maximize tax savings.

The QTIP gives you another way to avoid the pitfalls. When your will sets up a QTIP and gives the executor discretion to fund it, you don’t have to constantly revise your will or come up with the correct funding formula. You also don’t have to leave the decision to your grieving spouse. The QTIP has the additional benefit of extending the decision deadline six months.

With the QTIP, the executor could consider the amount that currently could be left tax-free to heirs, the tax law changes scheduled over the next 15 months, the income needs of the surviving spouse, and the health of the surviving spouse. Then the executor decides when to make the election, how much wealth to put in the QTIP trust for the surviving spouse, and how much property goes to the rest of the estate.

A variation is the Clayton QTIP. Under this strategy, the property that the executor elects not to put in the QTIP can be put in a traditional bypass trust under the terms of the will. That way, the property in the bypass trust qualifies for the estate tax exemption. But it does not have to be given directly to the other heirs immediately and can be managed by a trustee. The bypass trust also can give the surviving spouse a right to income or property from the trust as needed. That provides a cushion for the spouse in case circumstances change.

There are several potential disadvantages to the QTIP. If too much wealth is put into the QTIP trust, the income payments to the surviving spouse could cause his or her estate to continue increasing, triggering higher estate taxes down the road. Fully funding the QTIP trust also limits who immediately benefits from the estate of the first spouse dies.

Another potential disadvantage is that the trust might grow in value, triggering substantial estate taxes on the surviving spouse’s death. This problem could be reduced by giving the spouse and trustee the discretion to take principal out of the trust, even for the purpose of giving it to others.

If your estate’s primary asset is an IRA, be careful of the QTIP. It is possible to put an IRA in a trust that qualifies for the QTIP election. But the trustee must be able to withdraw all IRA income each year and distribute it to the surviving spouse. Some estate planning specialists believe it isn’t possible to meet all the hurdles. You need an experienced estate planning advissor to attempt it.