QTIP trusts (formally known as Qualified Terminable Interest Property) have gained in popularity in recent years. In the right situation, they can be a home run. In the wrong situation, they can be a big strike out.
The advantages are clear. But in the current tax regime, QTIP trusts pose some disadvantages when compared to other trusts. In this article, we will discuss the disadvantages (or cons) of QTIPs. Make sure that you understand the pitfalls associated with these powerful trusts.
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Conflicts Between Surviving Spouse and Remainder Beneficiaries
The main disadvantage of a QTIP trust is conflicts it can generate between the remainder beneficiaries and the surviving spouse. These conflicts can relate to tax strategy, investment decisions, and overall trust administration.
The conflict results from the surviving spouse’s lack of control over any remaining interest. In addition, the fact that the first spouse controlled the final disposition of the property after the death of the surviving spouse can cause problems. The likelihood for family conflict depends on:
- The relationship between the surviving spouse and the remainder beneficiaries, who are often children from a prior marriage.
- The surviving spouse’s income and assets from sources other than the QTIP.
No Allocation Power
Because the surviving spouse must be the sole beneficiary of the QTIP trust, the trustee may not make distributions from the QTIP trust to persons other than the surviving spouse during the surviving spouse’s lifetime.
As a result, unlike the trustee of a bypass trust, the trustee of a QTIP trust cannot allocate trust income and principal among younger generation family members. Of course, this places the surviving spouse in no worse position than if an outright bequest to the spouse had been made.
The surviving spouse can still use their property to make annual exclusion gifts to those persons (or, after a portability election, make even larger taxable gifts by using their DSUE amount) without paying any gift tax.
Inability to Obtain Funds to Make Tax-Advantaged Tax Gifts
A QTIP trust does not require the restriction of the surviving souse’s ability to withdraw principal from the trust to qualify for the marital deduction. However, a typical QTIP will not grant liberal withdrawal powers to the surviving spouse.
The surviving spouse might exercise any withdrawal powers to counteract the objectives of the first spouse regarding the assets of the remainder interest upon the death of the surviving spouse. Due to the surviving spouse’s limited withdrawal powers, they may not obtain the necessary funds from the QTIP to make gifts that could fall under the annual gift exclusion amount.
Estate Tax Exposure
Presumably, the QTIP trust has been used to achieve a step-up in basis in the inherited assets when the surviving spouse passes away. This assumes that the trust assets appreciate. The basis adjustment is achieved by subjecting the assets to estate tax at the surviving spouse’s death.
The premise of using this technique is that the surviving spouse’s basic exclusion amount (or applicable exclusion amount, if portability is elected) will be sufficient to offset any estate tax.
However, there is a risk that the “guess” made about this exposure could be wrong. This exposure could arise from either the growth of the spouse’s or QTIP trust’s assets or a legislative change that reduces the estate tax exemption.
If these events occur, the QTIP trust could expose the assets to estate tax. Again, this risk is no greater than if an outright bequest to the spouse had been made. However, if the source of the tax is appreciation in the value of the QTIP trust assets between the first and second death, and if the income tax savings from the basis adjustment is less than the estate taxes payable, then using a bypass trust instead could have been more beneficial. This is not one of the more clear cut disadvantages.
Income Tax Exposure
A QTIP trust is a “simple” trust for federal income tax purposes in that it must distribute all income at least annually. Remember that simple trusts may pay income taxes.
As noted above, a trust that distributes all of its “income” must only distribute income as defined under the governing instrument and applicable state law. This is not necessarily all of its taxable income. For example, capital gains, which are taxable income, are typically treated as corpus under local law and therefore not distributable as income.
Other differences between taxable income and state law income could further trap taxable income in the trust. While simple trusts often accumulate less taxable income than complex trusts, they may be subject to income tax at compressed tax rates.
The QTIP Tax Apportionment Trap
Remember that if estate tax ultimately proves to be due to having made the QTIP election, the source of payment for these taxes becomes essential. Under federal law, except to the extent that the surviving spouse in their will (or revocable trust) indicates explicitly an intent to waive any right of recovery, the marginal tax caused by the inclusion of the QTIP assets in the surviving spouse’s estate is recoverable from the assets of the QTIP trust.
Many state tax apportionment statutes adopt this rule, either expressly or by reference. When the beneficiaries of the surviving spouse’s estate and the remainder beneficiaries of the QTIP trust are the same persons, this rule generally makes little difference. Where they differ, however, the result could be dramatic and highlights the need to check the “boilerplate” of clients’ wills.
Disadvantages of QTIPs
QTIPs have many pros and cons. In the current tax environment, QTIP trusts can have some disadvantages to carefully review. Make sure that you understand how these trusts work and if they will work for you in your situation.
As you can see there are a few concerns you might have regarding QTIPs. This is applicable to investment accounts and any other assets. Make sure you discuss with your attorney.
