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

April 10, 2023

QTIP Trust Planning Before 2026

Take-Away: As we inch towards 2026 and a return to planning for (or around) federal estate taxes, some surviving spouses should take a look at their existing QTIP trusts which may cause their estates to pay federal estate taxes on their deaths. Getting out of a QTIP trust is a pretty complex process, with plenty of tax ‘traps’ along the way.

Background: Over the years many qualified terminal interest property trusts (QTIP trusts) have been created for spouses and surviving spouses. The downside to a QTIP trust is that it can create some estate tax  difficulties for the surviving spouse. Specifically, the full value of the QTIP trust is included in the surviving spouse’s taxable estate. [IRC 2044.] While the surviving spouse as the QTIP beneficiary must receive all of the income generated by the trust’s assets, there is no requirement that the surviving spouse ever receive any principal distributions from the QTIP trust. Thus, while the surviving spouse does not ‘own’ the QTIP trust’s assets, their value is nonetheless treated as being owned by the surviving spouse on his/her death. Since the QTIP trust principal is included in the surviving spouse’s taxable estate, often the question arises how to ‘unwind’ the QTIP trust to minimize the future federal estate tax liability caused the QTIP trust’s inclusion in the surviving spouse’s taxable estate. QTIP trusts may become even more of an estate planning concern as the 2026 ‘sunset’ of the surviving spouse’s large applicable exemption amount approaches.

Options: Limited options exist with regard to ‘unwinding’ a QTIP trust to mitigate future federal estate taxes faced by the surviving spouse’s estate. None is perfect.

Gift of QTIP Income Interest by Survivor, But Gift Tax Concerns: The surviving spouse/beneficiary of the QTIP trust can gift part or all of his/her income interest in the QTIP trust.

  • Spendthrift Clause: One practical hurdle to this gift of a QTIP trust income interest is the presence of a spendthrift clause in the QTIP trust. Perhaps that spendthrift clause impediment can be amended out of the QTIP trust by a trust director, or through a trust modification proceedings, but the modification process is doubtful if the spendthrift provision is deemed to be a material purpose of the QTIP Trust.
  • Gift of Remainder Interest: A gift of the QTIP trust income interest by the spouse-beneficiary is not only of their income interest, but it is also treated as a gift of the entire value of the QTIP trust, including the trust’s remainder interest. [IRC 2519.] The gift tax value of the deemed remainder interest in the QTIP trust can be calculated as a net gift since the survivor who makes this lifetime gift can recover the federal estate tax he/she is obligated to pay if the QTIP trust formed on the death of the first spouse. The surviving spouse would be able to use his/her larger applicable exclusion amount before it drops in 2026 in order to ‘freeze’ the value of assets in the QTIP trust. This gift of the income interest in the QTIP trust would have to be weighed against the loss of a future step-up in income tax basis of the QTIP trust assets on the surviving spouse’s death.

Gift of Some QTIP Income, But ‘Claw Back’ Concerns: Note that even if the surviving spouse only gave way 10% of his/her income interest in the QTIP trust, he/she would still be treated as having gifted 100% of his/her income interest in the QTIP trust. If the QTIP trust remainder beneficiaries are family members, which is frequently the case, then that gift of a part of the income interest will be treated as if a gift is made of 100% of the value of the QTIP trust, no matter how much the surviving spouse has retained of the income interest. [IRC 2702.]  In addition, with the recently published proposed ‘anti-claw back’ Regulations, this fractional gift of the QTIP trust’s income interest might also cause the surviving spouse’s estate to not be able to use their larger applicable exemption amount  when the lifetime income interest gift occurred, (i.e. the ‘includible’ interpretation of the Proposed Regulation’s ‘anti-claw back’ exception) and instead have to use the survivor’s lower applicable exemption amount if the survivor dies after 2025.

  • Divide and Conquer Solution?: A possible planning ‘work-around’ associated with the survivor’s gift of an income interest in a QTIP trust is for the QTIP trust to be divided, followed by a trust modification [Private Letter Ruling 202116001] or a disclaimer by the survivor of an interest in the QTIP trust [Private Letter Ruling 202146001.] These two PLRs describe how a surviving spouse can surrender a portion of his/her income interest in the QTIP trust without triggering a gift tax on all of the survivor’s interest in the QTIP trust. By dividing the QTIP trust prior to the gift, relinquishing the interest in one QTIP trust, will not be treated as a relinquishment of the survivor’s interest in the ‘other’ QTIP trust. Since the two QTIP trusts will be treated separately for transfer tax purposes, the relinquishment of income under one QTIP trust will not trigger IRC 2702 treatment for the’ other’ QTIP trust.

Sale of Part or All QTIP Income Interest: The surviving spouse could sell part, or all, of his/her income interest in the QTIP trust. Many of the results are the same as if the survivor gave away their income interest in the QTIP trust. However, there is yet another adverse income tax consequence associated with a sale, which is that with such a sale of the income interest, the income tax basis of the income interest when disposed of will be $0.00. [IRC 1001(e)] thus triggering a capital gains tax on the entire amount of the sales proceeds received.

Survivor Purchases QTIP Remainder Interest: The surviving spouse could purchase the remainder interest in the QTIP trust from the trustee. While this purchase would deplete the value of the survivor’s estate by their payment or the purchase  price for the QTIP trust’s remainder interest, that would still expose the value of the purchased QTIP trust remainder interest to taxation in the survivor’s taxable estate.  In Revenue Ruling 98-8, the purchase of the QTIP trust remainder interest was treated as a termination of the spouse’s income interest which, in turn, triggered a gift tax; the spouse’s consideration for receiving ‘back’ the QTIP trust remainder interest was not treated as ‘full consideration in money’s worth’ as it did not augment the surviving spouse’s estate in  the IRS’s view.

Commutation of QTIP with Actuarial Interest:  A commutation of the surviving spouse’s income interest in the QTIP trust results in a net gift by the survivor. However, the QTIP trust remainder beneficiaries will not be treated as having made a gift to the surviving spouse. [Chief Counsel Advisory, CCA 202118008.] A commutation of interests in the QTIP trust ‘freezes’ the value of the QTIP trust assets held by each party after the commutation. This, however, creates another risk. In Private Letter Ruling 201932001, the IRS took the position that a similar transaction should be viewed as a purchase of the income interest by the remainder beneficiaries under IRC 1001(e).

  • Partnership?: This adverse result in the PLR  might be avoided if the instead of terminating the QTIP trust through a commutation, the survivor and the remainder beneficiaries transfer their respective interests in the QTIP trust to a partnership, after which they then claim that no gain on their transfers is recognized on the ‘formation of a partnership.’[IRC 721(a).] Later, if the survivor transfers his/her partnership interest, he/she may be able to use their basis in the partnership interest to avoid income tax, except on any appreciation. In order to avoid some claim that the commutation of interests resulted in a merger, which would terminate the QTIP,  it would be wise to have different trustees involved from  which it can be argued from that no merger if the current and remainder interests in the trust  occurred.

Distribution of QTIP Property to Survivor: This is probably the most common approach used to deal with a QTIP trust with regard to the surviving spouse’s own estate plan. Practically speaking, however, the success of a distribution depends on the scope or latitude of discretion giving to the trustee under the QTIP trust to make principal distributions. If the trustee’s power to invade trust principal is limited to ‘health, education, support, and maintenance’ that may prove to be too limiting to enable the trustee to make distributions of principal to the survivor to enable them to  plan their own estate. If the power to invade principal of the QTIP trust was expanded to include “the authority and right to allow distributions of principal to the spouse to enable the spouse to engage in estate planning,” that broadened discretionary distribution power would permit distributions of trust principal to the survivor who can then gift assets or use other valuation depression strategies, e.g. family LLC’s.

  • Kite Decision: The danger associated with the distribution  planning approach is the infamous Tax Court decision, Estate of Kite v. Commissioner, Tax Court, Rule 155, No. 6772-08 ( October 25, 2013). In that case the trustee distributed QTIP trust principal to the spouse-beneficiary. The spouse sold the distributed assets to an irrevocable trust established for her children. The spouse received as the purchase price from the trust a deferred annuity. The IRS argued that the distribution from the QTIP trust was part of a preconceived plan to exchange fair market value asset for a heavily discounted deferred annuity. The Tax Court held that the distribution-sale of assets was actually a commutation of the surviving spouse’s interest in the trust. Accordingly, the spouse had to pay gift tax on the remainder interest that she ‘received’ in the ‘collapsed’ transactions.

Conclusion: While there are several possible strategies available to ‘unwind’ a QTIP trust as part of  the surviving spouse’s overall estate plan, each possible strategy comes with some tax-cost. The important point to remember is that with a QTIP trust, the value of the QTIP trust assets is included in the surviving spouse’s taxable estate, but the actual trust assets themselves may not be readily available to the survivor’s estate with which to pay the estate tax associated with the trust. The QTIP trust itself must contain a provision that authorizes the trustee of the QTIP trust to use trust assets to pay the deceased spouse’s estate tax liability associated with the QTIP trust.