Trusts are helpful for many different purposes. They can be used to manage and safeguard the property gifted to or inherited by minors or other persons who may be unable to manage their affairs. Trusts are often touted as a way to avoid probate. Trusts can also be utilized to shield property from the creditors of a beneficiary. Many trusts are designed to transfer property in a way that minimizes estate and gift taxes.
Probably the most used type of trust used to address these issues is a “Qualified Terminable Interest Property” or “QTIP” trust. A QTIP provides that the surviving spouse is the only beneficiary during their lifetime and that all of the trust’s net income must be distributed outright to the surviving spouse at least once a year.
A QTIP is a unique form of marital trust that allows net income to be distributed to the surviving spouse annually. No other beneficiary besides the surviving spouse is permitted during the spouse’s lifetime. The spouse may also receive additional amounts for health and support.
Bypass Trust QTIP Issues
If the trust is structured correctly, it will qualify for the unlimited marital deduction. As such, no federal estate tax is due upon the death of the first spouse. The assets contributed to the QTIP will get a step-up in basis.
But then comes more good news. When the surviving spouse dies, the entire QTIP amount will be included in their taxable estate. As such, the QTIP assets will get the second step-up at that time. Not such a bad deal.
Assuming there is appreciation in the QTIP assets during the surviving spouse’s lifetime, the assets will get a new cost basis and can be sold or disposed of without any capital gain tax. The result is that there is no federal estate tax if the value of the QTIP and the surviving spouse’s assets are less than the $11.7 portable exemption received from the first spouse plus the surviving spouse’s exemption. Sounds like a great deal.
If structured correctly, the spouse can receive distributions of trust principal as needed. The QTIP trust’s terms determine who receives the remaining assets when the surviving spouse passes away.
If a trust is designed as a QTIP trust, but a valid QTIP election is not made, then the trust assets will not be included in the surviving spouse’s estate at their death, and no second basis step-up for the trust’s assets will be available. However, suppose a proper QTIP election is made after the first spouse’s death. In that case, the assets retained in a QTIP trust when the surviving spouse passes away are still included in the surviving spouse’s estate and gets another (second) basis step up.
The couple can use a QTIP trust to protect the surviving spouse’s income and maintain control over the final distribution of the assets for the first spouse. All along, it will still receive a second basis step-up at the surviving spouse’s death. It can also rely on the portability election to preserve the first spouse’s exemption amount.
Here is how the estate planning should be structured. The first spouse’s estate documents provide a QTIP trust to be created at their death for the surviving spouse’s benefit. Upon the first spouse’s death, the estate’s executor should timely file IRS Form 706 for the first spouse’s estate.
This filing is necessary no matter what the value of the first spouse’s estate. On the estate return, the executor must make both of the below elections:
- The QTIP election that allows the amount for which the QTIP election is made to qualify for the marital deduction and does not use any of the first spouse’s exemption amount; and
- The portability election so that the first spouse’s unused exemption amount transfers over to the surviving spouse.
There are many types of trusts designed to accomplish different goals. Some of these goals relate to reducing income and transfer taxes, and some of these goals are entirely unrelated to taxes. Trusts are often complicated and misunderstood.
Hopefully, this summary of the basic rules governing the creation and taxation of trusts and the descriptions of how some of the more common trusts are utilized will help design wealth transfer plans for you and your clients.