Take-Away: There are occasions, albeit infrequent, when a QTIP Trust for a surviving spouse creates difficulties when the spouse-beneficiary dies. There are few options to consider if the decision is made to exit a QTIP Trust, but each carries its own unique tax implications.

Background: A QTIP Trust for a spouse defers federal estate taxes (or gift taxes) until the spouse-beneficiary’s death. The assets held in the QTIP Trust are  included in the spouse-beneficiary’s taxable estate [IRC 2044], which creates a potential federal estate tax problem. However, those same QTIP Trust assets will also enjoy the possibility of an income tax basis ‘step-up’ on the spouse’s death. The ‘rules’ for qualifying for the marital deduction QTIP treatment are familiar to all: (i) the spouse must receive all income for his/her lifetime (but there is no requirement that the spouse-beneficiary receive any trust principal); (ii) only the spouse can benefit from the trust; and (iii) the spouse must have the ability to compel the QTIP trustee to make the trust assets income producing. It is possible to give to the spouse-beneficiary a testamentary limited power of appointment over the QTIP Trust assets, adding some flexibility to the plan.

Options for Exiting a QTIP Trust: While a QTIP Trust is often used as a part of an estate plan, there might be occasions when the spouse-beneficiary no longer wants, or needs, to retain an interest in the QTIP Trust.

Example: Stu and Jean were married for a long time. Stu ran the family business which was in his name alone. Stu died in 2001 at age 50. On Stu’s death, his estate plan funded a credit shelter (Family) trust and also a QTIP Trust for Jean’s lifetime benefit. Jean received outright title to their home and Stu’s 401(k) plan on his death. Stu’s business interests funded both the QTIP Trust and the Family Trust on his death. It is now 2022. Jean is now 71. Their children run the business.  Currently the value of the Family Trust, of which Jean is the income beneficiary with the right to receive discretionary HEMS distributions, is worth $7.0 million. The QTIP Trust is now worth $11 million-it still holds the family business. Jean’s own assets (the home and Stu’s 401(k) account which was rolled over to Jean’s own traditional IRA, are collectively worth $6.0 million  ($1.0 million home; $5.0 million in a traditional IRA.) If Jean dies, she will have a taxable estate of $17 million ($11 million in the QTIP Trust + $6.0 million in her own assets.)  Jean can use her own $12.0 million applicable exemption amount, but that would then leave roughly $5.0 million exposed to federal estate taxes, or a federal estate tax liability of $2.0 million. [Note- Stu died before there was portability.] The estate tax problem gets worse if Jean survives to 2026 when her applicable exemption amount drops to $6.0 million, which would cause her estate to pay an estate tax of roughly $4.4 million. Jean does not need the income from the QTIP Trust, since she will soon be taking RMDs from her traditional IRA and she continues to receive income from the Family Trust. How does Jean escape the QTIP Trust and what are the tax consequences when Jean escapes?

  1. Gift of All or Part of the QTIP Trust Income Interest:

Note: This option may not exist if the QTIP Trust contains a spendthrift limitation. If such a clause does exist in the QTIP Trust, it may be possible to amend the QTIP Trust to remove it,  or the trustee  decant the QTIP Trust to eliminate the spendthrift limitation.

IRC 2019: If the income interest in the QTIP Trust is gifted by the beneficiary spouse, IRC 2019 will treat the gift as a gift of the entire value of the QTIP Trust, including the QTIP Trust remainder interest. The gift tax value of the deemed remainder interest is calculated as a net gift as the spouse making the gift can recover the estate tax he/she is obligated to pay. Thus, the beneficiary spouse may be able to use his/her applicable exemption amount now before it drops in 2026, while it freezes the value of the assets in the QTIP Trust. The trade-off is the loss of the basis step-up of the QTIP Trust assets on the beneficiary-spouse’s death.

IRC 2702: Even if the beneficiary-spouse gave away just 10% of his/her income interest in the QTIP Trust, the gift is treated as giving away all (100%) of the income interest. If the remainder beneficiaries of the QTIP Trust are family members, e.g. the spouse’s children, then under IRC 2702 the gift of the smaller percentage of the QTIP Trust income will be treated as if a gift is made of 100% of the value of the QTIP Trust- no matter how much the beneficiary-spouse retained. Again, this approach might secure and use the spouse’s larger applicable exemption amount while it still exists, but there is also now the risks that (i) IRC 2036 will apply to cause the QTIP Trust assets to be included in the beneficiary-spouse’s taxable estate and that (ii) the recently proposed exception to the anti-claw back rule will apply, meaning the smaller applicable exemption amount will apply if the spouse dies after 2025..

Planning: One way to mitigate some of the tax consequences associated with a gift of the QTIP Trust income interest is to divide the QTIP Trust before the beneficiary-spouse makes the gift of the income interest. Then, the spouse-beneficiary can relinquish the income interest in one of the two QTIP Trusts, while the other QTIP Trust will remain and will not be affected by the gift of the income interest in the other QTIP Trust. Accordingly,  IRC 2702 will not apply to the ‘other’ QTIP Trust that continues, as the two Trusts are treated separately for tax purposes.  Authority to divide an existing QTIP Trust can be found in two Private Letter Rulings [PLR 202116001, division followed by modification of the Trust; PLR 202146001, division followed by a disclaimer of an interest in the Trust.]

  1. Sale of All or Part of the QTIP Trust Income Interest: All of the issues discussed above also apply to this scenario where the spouse-beneficiary sells his/her income interest in the QTIP Trust..

IRC 1001(e): However, there will be adverse income tax consequences that results from the sale of the QTIP Trust income interest, which triggers income tax. Under IRC 1001(e) the tax basis of income interests when disposed of by sale is zero.

  1. Purchase by Spouse of QTIP Remainder Interest: If the beneficiary-spouse purchases the QTIP Trust remainder interest from the remainder beneficiaries, then there is a merger of the current and future interests in the trust assets, and the QTIP Trust terminates. The problem is then that the QTIP Trust assets are will be included in the spouse’s taxable estate at death, but the value of the spouse’s estate will have been depleted by the payment made of the remainder interest.

Revenue Ruling 98-6: This Revenue Ruling treated the termination of the income interest as triggering a gift tax and the consideration of getting back the trust’s remainder interest was not treated as full consideration in money or money’s worth, as it did not augment the purchaser’s (the spouse’s) estate.

  1. Commutation of QTIP Trust Taking Actuarial Interest:  This approach results in a net gift by the spouse, where the QTIP Trust remainder beneficiaries are not treated as making a gift. [Chief Counsel Advisory 202118008.] The commutation freezes the value of trust assets.

PLR 201932001: Recently, the IRS took the negative position that a similar commutation transaction among trust beneficiaries should be viewed as a purchase of the income interest by the remainder beneficiaries under IRC 1001(e).

Partnership?: What if the beneficiary-spouse and the remainder trust beneficiaries each transfer their respective interests in the QTIP Trust to a partnership and each claimed that there was no gain on the transfer of their interests as their capital contributions to the partnership? [IRC 721(a).] The spouse then later transfers his/her partnership interest to avoid income taxes, except on any future appreciation.

  1. Distribute QTIP Property to Spouse: If the QTIP Trustee possesses broad latitude to make discretionary principal distributions to the spouse, the QTIP Trust assets could be distributed to the spouse in order to enable him/her to do their own estate planning. Most trustees, before exercising this broad discretion, will likely want  to see express authority given in the QTIP Trust instrument to allow distributions of principal to the spouse to enable the spouse to engage in their own estate planning.

Kite v. Commissioner ( Tax Court, 2013): This  decision creates possible problems. There, the trustee made a principal distribution to the beneficiary-spouse. The Tax Court found that distribution  to be a part of a ‘preconceived plan.’ That is because the spouse then promptly sold the distributed assets to a trust established for her children, in exchange for an annuity. The Tax Court held that this combined transaction was essentially a commutation by the spouse and she had to pay a tax on the remainder interest that she received, in the form of the annuity. The purchase price received was a deferred annuity. This risk might be mitigated to some degree if there is considerable time between the trustee’s distribution from the QTIP Trust and the sale by the spouse so that the IRS cannot claim there was a unified, preconceived plan collapsing the two transactions into one.

Conclusion: For almost all of these options to be considered, the first step is to determine if there is a spendthrift limitation in the QTIP Trust, and if so, find a way to eliminate it from the QTIP Trust. The interesting utility of IRC 2519 is the ability of the spouse-beneficiary to fully use their currently large applicable exemption amount now,  before it is cut in half beginning in 2026, while still  retaining the right to receive discretionary principal distributions from the QTIP Trust. All part of the ‘use-it-or-lose-it’ game planners now play in anticipation of 2026.