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George F. Bearup, J.D. Senior Legal Trust Advisor

13-Feb-19

Lifetime QTIP Trusts: Revisiting an Old Friend

Take-Away: The settlor of a lifetime QTIP trust can become the beneficiary of the QTIP marital trust on the death of the settlor’s spouse and continue to protect the trust’s assets from creditors, even though that trust could easily be classified as a self-settled trust and otherwise exposed to satisfy the settlor’s creditor claims at common law. In addition, a lifetime qualified terminable interest property (QTIP) trust can be used to exploit the deceased beneficiary-spouse’s GST exemption, which cannot otherwise be used by the surviving settlor-spouse with a portability election.

Background: Much has been written over the past couple of years with regard to Michigan’s foray into the self-settled asset protection trust world with its enactment of the Michigan Qualified Dispositions in Trust Act. [MCL 700.1041 to 700.1050.] Prior to the authorization of that new self-settled trust regime, a narrow opportunity existed under Michigan law that permitted a self-settled trust to thwart the settlor’s creditors but without all of the preconditions that must be met under the Michigan Qualified Dispositions in Trust Act including the filing of a solvency affidavit. That self-settled trust opportunity continues with the use of a lifetime qualified terminable interest (QTIP) trust that is created for the settlor’s spouse’s lifetime benefit.

QTIP Trust: While lifetime QTIP trusts may have lost some of their luster with the advent of the portability of a deceased spouse’s unused applicable exemption amount, a QTIP trust can provide creditor protection, not only for the beneficiary-spouse during his/her lifetime, but also for the settlor-spouse if he/she becomes the secondary beneficiary of the QTIP trust at a later date (often referred to as an overlife interest) if the QTIP trust instrument contains a spendthrift provision. [MCL 700.7502.]  Moreover, while portability may no longer prompt spouses to consider the use of a lifetime QTIP trust for federal estate tax avoidance purposes, if the couple’s ultimate estate planning objective is to make transfers on their deaths to younger generation family members, or to a dynasty-type trust  for multiple generations of descendants, because a deceased spouse’s generation skipping transfer tax (GST) exemption is not portable, a lifetime QTIP trust can be used so that the deceased spouse’s GST transfer tax exemption can be used through a reverse QTIP election.

“Deemed Transferor:” A qualified terminable interest trust is intended to qualify for the unlimited marital deduction for either the federal estate tax [IRC 2056(b)(7)] or the federal gift tax. [IRC 2523.] Any federal transfer taxes will be deferred until the surviving spouse’s death or the donee-spouse-beneficiary’s death. The beneficiary-spouse (on death) is deemed to be the “transferor” of the QTIP trust’s assets for estate tax purposes, so that the value of any assets that remain in the QTIP trust at the beneficiary’s death will be included in his/her taxable estate and taxed at that time. [IRC 2044.] This same “deemed transferor” treatment applies to a lifetime QTIP trust created for a spouse as well.

QTIP Trust Requirements: In order to obtain the transfer tax marital deduction benefits a lifetime QTIP trust must meet several strict requirements. (i) the property must pass from the settlor-spouse to an irrevocable trust; (ii) the beneficiary-spouse must be a U.S. citizen; (iii) the beneficiary-spouse must be entitled to receive, annually, all of the trust’s income for his/her life; (iv) the beneficiary-spouse must possess the right to demand that non-income producing property held in the QTIP trust be converted to income producing property; (v) no other beneficiary can possess any rights in the trust during the beneficiary-spouse’s lifetime; and (vi) an irrevocable QTIP election must be made on a federal gift tax return, Form 709. [IRC 2523(f).] As noted, like a testamentary QTIP trust, the beneficiary-spouse will be treated as the “transferor” of the QTIP trust assets on the beneficiary-spouse’s death.

Potential GST Benefits: A lifetime QTIP trust offers a variety of tax advantages for married couples as well as asset protection without some of the qualifying hassles that are associated with a Michigan Qualified Dispositions in Trust. A lifetime QTIP trust enables gift tax-free gifting between spouses. For spouses in a second marriage where there exists unequal wealth, it permits the wealthier spouse to transfer assets to an irrevocable trust where the value of those assets will be taxed in the beneficiary-spouse’s estate, where his/her transfer tax exemption can be used, with a corresponding increase in those trust assets’ income tax basis on the beneficiary’s death. Those continuing trust assets can then pass on the settlor’s subsequent death to the settlor’s heirs. The QTIP trust also permits the use of both spouse’s GST exemption amounts if dynasty-type trusts are part of their ultimate estate disposition after both of their deaths with a reverse QTIP election by the beneficiary-spouse on his/her death. Note that there is no portability of a deceased spouse’s GST tax applicable exemption amount, so it must either be used, or forever lost. With regard to the continuing trust for the settlor’s overlife, that trust could also be established as a grantor trust for income tax reporting purposes, which would enable that overlife beneficiary to make indirect tax-free gifts to the continuing trust’s remainder beneficiaries through the overlife beneficiary’s payment of the continuing trust’s income tax liability.

Example: Herb and Wendy are married. Herb creates a lifetime QTIP trust for Wendy’s lifetime benefit with a spendthrift provision. Wendy predeceases Herb. The QTIP trust instrument that Herb created provides that Herb is the next lifetime beneficiary of the continuing trust (i.e. Herb has an overlife in the former QTIP trust.)  Some of the consequences of this continuing trust arrangement follow:

  • Since all income generated by the QTIP trust must be distributed annually to Wendy, that income will be taxed to and reported by Herb and Wendy on their Form 1040, despite the QTIP trust owning the income producing assets.
  • On Wendy’s death the value of the QTIP trust’s assets will be includible in Wendy’s taxable estate on her death. [IRC 2044.] The value of those assets held in the QTIP trust will also receive a basis adjustment to their fair market value as of the date of Wendy’s death. [IRC 1014.]
  • The QTIP trust instrument could either be drafted as a continuing QTIP trust for Herb’s lifetime benefit, or a more conventional credit shelter trust, again where Herb is the lifetime beneficiary during Herb’s Wendy’s estate could either make a QTIP election under IRC 2056(b)(7) for the continuing [QTIP] trust for Herb’s overlife and thus qualify for the federal estate tax marital deduction, or no election would have to be made by Wendy’s estate, in which case the continuing [former QTIP] trust would function like a conventional credit-shelter trust.
  • If the continuing trust for Herb’s overlife is treated as a non-marital ‘credit-shelter’ type of trust at Wendy’s death, then the continuing trust’s assets would not be included in Herb’s taxable estate at his subsequent death under either IRC 2036 or IRC 2038, inasmuch as Wendy is deemed to be the “transferor” of the assets held in the continuing trust. [Restated, Herb is not treated as if he retained an interest in the continuing trust, which is the trigger word used for estate inclusion on Herb’s death.] If Wendy has any unused transfer tax exemption amount available to her estate at her death, then a QTIP election might not be made for Herb’s interest in the continuing trust, so that Wendy’s available estate tax exemption would shelter that transfer from any future federal estate taxes.
  • There is no risk of inclusion of the value of the QTIP (continuing) trust assets in Herb’s estate on his following death if no second QTIP election is made by Wendy’s estate- it would function like a conventional credit shelter trust.
  • Wendy’s estate could also apply her available GST exemption to the assets held in this ‘credit shelter’ type of trust, thus making those assets GST exempt when they are distributed after Herb’s death.
  • As an alternative, Wendy’s estate could make a QTIP election under IRC 2056(b)(7) for the continuing trust for Herb’s lifetime benefit and thus claim the marital deduction with respect to the QTIP trust’s assets- the effect of which would be to defer any federal estate taxes until Herb’s subsequent death.  During the Herb’s overlife he will presumably receive all of the income generated by the QTIP trust. However, the trust instrument could be drafted, as an alternative, that Herb would not possess the right to receive all of the trust’s income if Wendy’s estate does not elect that the continuing trust to be treated as a QTIP marital deduction trust. A reverse QTIP election could be made by Wendy’s estate which will have the effect of using Wendy’s available GST tax exemption amount to shelter the continuing trust’s assets from future GST taxation. Wendy’s GST tax exemption cannot be ported and used by Herb on his future death, so it is important that Wendy’s GST exemption be used on her death. If other non-QTIP trust assets are actually used to pay the federal estate taxes on Wendy’s death, the payment of that additional federal estate tax liability using non-QTIP trust assets in Wendy’s estate will not constitute a gift to the continuing trust for Herb for GST tax exemption purposes. [Treas. Reg. 26.2652-1(a)(3).]
  • One potential disadvantage to the use of a lifetime QTIP trust either for Wendy, or for Herb, is the requirement that all trust income must be distributed to the beneficiary for life or for the successor beneficiary’s overlife. If the reverse QTIP election is made so that the QTIP trust continues as GST tax exempt trust during Herb’s overlife the effect of the obligation to distribute all income from that continuing trust will be a ‘leakage’ of it asset value that is intended to compound in the GST-exempt QTIP trust. This leakage problem can be mitigated to some extent if the continuing QTIP trust invests primarily in assets that do not produce income, i.e. high growth, low yield investments so little income is paid to Herb during his overlife.

Creditor Protection- the Self-Settled QTIP Trust: The settlor-spouse of a lifetime QTIP trust can become the next lifetime beneficiary of that same trust when his/her spouse dies. The settlor-spouse of the QTIP trust who transferred assets to the QTIP trust may nonetheless continue as the second, overlife, beneficiary of that continuing trust. [Treas. Reg.25.2523(b)-5(f)(4).] Even though the settlor-spouse is now the beneficiary of the very same trust that he/she created, the settlor-beneficiary spouse’s creditors cannot access that continuing trust’s assets, presuming the QTIP trust contains spendthrift provision. This result is achieved through a relatively innocent-looking provision in the Michigan Trust Code which deals with the ability of a judgment creditor to access the assets held in the continuing trust that originated with the settlor-beneficiary. MCL 700.7506(4) provides:

“An individual who creates a trust shall not be considered a settlor with regard to the individual’s retained beneficial interest in that trust that follows the termination of the individual’s spouse’s prior beneficial interest in the trust if all of the following apply: (a) the individual creates, or has created, the trust for the benefit of the individual’s spouse; (b) the trust is treated as a qualified terminable interest property under section 2523(f) of the internal revenue code, 26 USC 2523; and (c) the individual retains a beneficial interest in the trust income, trust principal, or both, which beneficial interest follows the termination of the individual’s spouse’s prior beneficial interest.” [MCL 700.7506(4).]

The result of this Michigan Trust Code section is that the settlor-spouse will not be treated as the “settlor” of the lifetime QTIP trust upon the beneficiary-spouse’s death when the assets held in the QTIP trust are included in the deceased beneficiary-spouse’s taxable estate. In effect, this section overrides other provisions of the Michigan Trust Code that permit the “settlor’s” judgment creditors or their assignees to access the assets that were transferred by the settlor to an irrevocable trust where the settlor retains the right to enjoy the transferred assets during his/her life, such as a conventional inter vivo revocable trust. [MCL 700.7506(1)(c).] In sum, the settlor’s beneficial interest in the original [QTIP] trust will not be treated as a self-settled trust and will thus its assets and the settlor’s interest in the trust will be protected by the trust’s spendthrift provision.