Wait and See Planning: Fine Tune a QTIP Trust

With the uncertainty that surrounds the possibility of tax law changes by Congress this year, what advice can an advisor provide to their clients when it comes to estate planning? We are left wondering if there will be a federal estate tax, a federal generation skipping transfer tax, a federal gift tax, a ‘step-up’ (or ‘down’) in the income tax basis of the decedent’s assets, or a deemed sale-on-death of a decedent’s capital assets on death above some dollar amount, i.e. a capital gain tax at death. The goal is to use flexible estate planning trusts that will protect assets and minimize the exposure to taxes, regardless of how the tax laws ultimately change. Trusts that are regularly used in estate planning deserve a fresh look in this period uncertainty to provide flexibility to respond to those future tax changes. For example a charitable remainder trust [CRAT] is effective to remove all capital gain from a donor’s taxable estate if there is a deemed sale on death capital gain tax. A grantor retained annuity trust [GRAT] is effective to remove appreciation from a settlor’s taxable estate gift-tax free if the federal estate and gift taxes continue in some form. Sales to an intentionally defective grantor trust [IDGT] will help to freeze the settlor’s estate without any gift tax liability and could be used to avoid any capital gain tax at death. The long-familiar qualified terminal interest trust (QTIP) for married couples which can provide flexibility to respond to an unknown tax future.

What’s New? Last year’s Revenue Procedure 2016-49 gave comfort to the effective use of a QTIP Trust as a part of a married couple’s estate plan. Rev. Proc. 2016-49 formally addressed a concern that arose in 2012 when Congress made permanent the ability of a surviving spouse to use their deceased spouse’s unused federal transfer tax exclusion amount, commonly called portability. Rev. Proc. 2016-49 addressed an earlier IRS Revenue Procedure [Rev. Proc. 2001-38] which had held that if a QTIP marital deduction election was not necessary to eliminate federal estate taxes on the death of a spouse, the IRS would treat it as void. Advisors were anxious that with the transfer of all of the deceased spouse’s property to a QTIP Trust, which would result in no federal estate tax liability due to the unlimited marital deduction, coupled with a portability election by the decedent’s estate, a QTIP election would not be respected by the IRS. Rev. Proc. 2016-49 eliminated this concern. The IRS announced that the transfer of a deceased spouse’s assets to a QTIP Trust, thus sheltered by the unlimited marital deduction could also be accompanied by a portability election to pass the deceased spouse’s unused federal transfer tax applicable exclusion amount to their surviving spouse and the QTIP election would be respected.

QTIP Tax Benefits: The result of Rev. Proc. 2016-49 is that: (i) there will be no federal estate taxes due on the decedent spouse’s death with the transfer of the decedent’s assets to a QTIP Trust that benefits the surviving spouse. [IRC 2056(b)(7)]; (ii) the surviving spouse will have full access to the decedent-spouse’s unused federal transfer tax exclusion amount for his or her own estate [IRC 2010(c)(5)(a)]; (iii) all of the assets held in the QTIP Trust will be subject to federal estate taxes on the surviving spouse’s subsequent death, but they could be sheltered by close to $11 million of the spouse’s combined federal estate tax exemption(s) [IRC 2044]; and (iv) all of those same capital assets taxed on the survivor’s death will enjoy a full ‘step-up’ (or ‘down’) in income tax basis on the survivor’s death. [IRC 1014(a) (10)] The deceased spouse’s estate can also make a reverse-GST election over the QTIP Trust, so that if that Trust is to continue long after the surviving spouse’s death for the benefit of multiple generations, that Trust will be generation skipping transfer tax (GST) exempt by virtue of the deceased spouse’s use of his/her GST exemption of $5.49 million. The decedent’s GST exemption is not available to be ported to their surviving spouse, so the GST exemption should be used if at all possible; nor can a reverse GST election be made in conjunction with any other type of federal estate tax marital deduction transfer.

QTIP Planning Benefits: There are many non-tax reasons to adopt a QTIP Trust.

• This type of trust is often used in a second-marriage situation where there is a blended family. The deceased spouse wants to make sure that his/her children from the prior marriage will receive the remaining trust assets on the surviving spouse’s death. The settlor-spouse thus controls the ultimate distribution of QTIP Trust’s assets on their surviving spouse’s death.
• The deceased spouse wants to provide a steady and reliable income stream to their surviving spouse for his/her lifetime.
• The deceased spouse wants to protect the principal assets held in the QTIP Trust from the surviving spouse’ creditors. While the required income distribution to the surviving spouse will be exposed to the surviving spouse’s creditors when the income distributions are actually made, the principal assets held in the QTIP Trust will be protected from those creditor claims.
• An independent trustee can make discretionary principal distributions to or for the benefit of the surviving spouse following whatever standard the deceased spouse imposes under the trust instrument.
• If the surviving spouse is unfamiliar with the management or investment of the capital assets held in the QTIP Trust, an independent trustee can be named to mentor the survivor with those responsibilities.

Clayton QTIP Election: A variation on the conventional testamentary QTIP Trust which can add additional flexibility in anticipation of future tax law changes is to draft the QTIP Trust with a Clayton election. With this feature the decedent spouse’s full estate passes to a trust that is established for their survivor’s lifetime benefit which is designed to satisfy the QTIP Trust rules, i.e. all income must be paid to the surviving spouse for life. But that same trust design also authorizes the decedent’s personal representative to elect whether all or only a portion of the decedent’s assets should pass to the QTIP Trust. That portion (if any) not elected to pass to the QTIP Trust then passes to a non-marital trust share, like a conventional credit shelter trust also established, for the survivor’s lifetime benefit.

Accordingly, the personal representative of the decedent’s estate decides whether to fund a credit shelter trust, thus absorbing the decedent’s then available federal transfer tax exemption amount, which then allows those credit shelter trust assets to later grow estate tax-free, and passed on to a future generation, albeit with no future income tax basis ‘step-up’ on the surviving spouse’s death. The creation of a credit shelter trust by making a Clayton election can also use the deceased spouse’s GST exemption, which is not available to be ported to the surviving spouse. If the personal representative concludes that the married couple’s combined assets appear unlikely to ever exceed their combined federal estate tax exemptions, the personal representative can decide to leave all of the decedent’s assets in the QTIP Trust and elect portability, where the capital assets will sustain an income tax basis ‘step-up’ (or ‘step-down’) on the surviving spouse’s death, but those assets may be subject to some federal estate taxes if that tax is phased out over an extended period. If the federal estate tax is replaced with a deemed sale-on-death capital gains tax, the personal representative might decide to not make a Clayton election since the credit shelter trust’s assets would not be owned by the surviving spouse at his/her death, so any appreciation that occurs to the credit shelter trust assets while the surviving spouse is alive would not be exposed to that deemed sale-on-death capital gain tax.

This ‘wait-and-see’ approach to make a QTIP election was first authorized in Estate of Clayton, 976 F.2d 1486, 70 AFTR2d 92-6262 (CA-5, 1992), and later was accepted by the IRS in Trea. Reg. 25.2518-2(e) (5), Example 5. If the Clayton election approach with its ‘wait-and-see’ flexibility has some appeal, it would be best to use an independent personal representative to make the election, and not the surviving spouse. Some commentators fear that if a surviving spouse acts as personal representative and makes the Clayton election the survivor might be viewed by the IRS as making a taxable gift to the beneficiaries of the credit shelter trust.

Clayton Election v. Disclaimer Trust: The Clayton election should be compared to another flexible planning approach called a disclaimer trust. With a disclaimer trust all of the decedent’s spouse’s assets pass to their surviving spouse in trust. The surviving spouse then decides to disclaim a portion (or all) of those assets. The disclaimed assets then pass to a credit shelter trust which is not treated as a marital deduction trust. The disclaimer forces the use of the deceased spouse’s federal transfer tax exemption with regard to those disclaimed assets that pass to the credit shelter trust. The assumption is that the surviving spouse will make a disclaimer only after looking at the existing tax laws and he/she will then disclaim some (or all) of the assets to minimize taxes on both spouses’ deaths. In other words, a disclaimer trust is yet another ‘wait-and-see’ approach to estate planning. However, a Clayton election provides some practical benefits over the disclaimer trust.

• In a second marriage situation, a spouse is reluctant to place all of their assets in the hands of their surviving spouse with the hope that the survivor will, in fact, make a qualified
• A Clayton election is made by the personal representative on the decedent’s final Form 706 federal estate tax return which with extension is due 15 months from the decedent’s death. A qualified disclaimer must be made by the surviving spouse within 9 months of when the interest in trust is conferred on the survivor, i.e. within 9 months of the decedent spouse’s death. If flexibility is dependent upon an informed ‘wait-and-see’ approach to future tax laws, the more time the personal representative has in which to make a decision to make a QTIP Clayton election of some (or all) of the assets that pass to the QTIP Trust, hopefully a more informed decision will be made, especially if there is a good chance of a phased-in repeal of the federal estate tax over several years.
• Several conditions go along with making a qualified disclaimer by the surviving spouse, such as not accepting, controlling or benefiting from the asset prior to it being disclaimed. These conditions all add to the risk that the surviving spouse’s disclaimer might not end up being a qualified disclaimer. The only requirement with the Clayton election is that it is made by the deceased spouse’ personal representative on the estate’s final Form 706.
• Despite sound tax reasons that may exist for a surviving spouse to make a qualified disclaimer, often overwhelming grief or the panic over outliving his/her money will govern the surviving spouse’s judgment; indecision often leads to a non-decision with regard to a qualified disclaimer which must be made within 9 months of the deceased spouse’s death.

Lifetime QTIP Election: Yet another variation on a flexible QTIP Trust is to create and fund a QTIP Trust while both spouses are alive. An irrevocable trust is created by one spouse for the other spouse’s lifetime benefit. A QTIP election is made on Form 709. [IRC 2523(f)] The transferred assets to the trust are covered by the unlimited federal gift tax marital deduction so no federal gift tax is due. [IRC 2519] Whether a QTIP election is made with regard to this transfer of assets to this lifetime trust depends upon if the federal estate and/or gift tax laws are repealed. The flexibility associated with a lifetime QTIP Trust is reflected by the following advantages:

• The lifetime QTIP Trust election is made on a federal gift tax return, Form 709, which is due, with extension, no later than October of the calendar year that follows the year of the gift to the trust is made by the donor-spouse. That delay in the decision to make the QTIP election provides additional time in which to decide if the QTIP election is warranted under the transfer and income tax laws then in effect.
• If the gift and estate taxes are repealed by Congress, the beneficiary-spouse could release his/her interest in the lifetime QTIP Trust, effectively terminating that Trust, perhaps causing the assets to pass to a dynasty trust that can benefit the entire family for generations, or merely back to the donor-spouse.
• If the federal estate tax is repealed but the federal gift tax remains, the QTIP election can be timely made to avoid the imposition of any federal gift tax.
• When the beneficiary-spouse dies, there will be estate tax inclusion of the value of the QTIP Trust assets in the beneficiary’s taxable estate, and a corresponding income tax basis ‘step-up’ (or ‘step-down’).
• The lifetime QTIP Trust assets will be protected from the beneficiary-spouse’s creditors, other than the income which must be paid to the beneficiary-spouse as a matter of right.
• The donor-spouse if he/she is alive at their spouse’s death can continue as the next lifetime beneficiary of the QTIP Trust (of which that donor-spouse was the original settlor.) The QTIP Trust assets will not be included in the donor-beneficiary’s taxable estate at the time of his/her death as they were taxed in the first spouse’s estate with a corresponding basis ‘step-up’ on that event. While there would be no ‘second’ basis ‘step-up’ (or ‘step-down’) on the donor-spouse’s subsequent death, the same assets would not be exposed to a deemed sale-on-death capital gains tax if that replaces the federal estate tax.
• If the beneficiary spouse dies and the donor-spouse then becomes the lifetime beneficiary of the QTIP Trust the assets will still be protected from the donor-spouse’s creditors. Michigan is one of a handful of states that adopted a statute that protects the assets held in the lifetime QTIP Trust from the donor-beneficiary’s creditors, even though that trust is essentially a self-settled trust. [MCL 700.7506(4) and MCL 700.7103(i)]

While advisors wait to see what Congress will provide in the form of tax simplification, it is important to keep in mind that many conventional estate planning devices, like a QTIP Trust, can be adapted to provide substantial flexibility to respond to many of those future tax law changes, whatever form they may take.