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

20-Oct-21

Reasons to Consider a Lifetime QTIP Trust

Take-Away: The estate planning community seems to be preoccupied with encouraging  married couples to adopt spousal lifetime access trusts (SLATs). An alternate estate planning strategy that might also be considered by a married couple is the gift to a lifetime qualified terminable interest property (QTIP) Trust.

Background: With the fear of a sudden reduction of an individual’s applicable exemption amount, many married couples have been encouraged to make taxable gifts to a spousal lifetime access trust (SLAT) for the benefit of their spouse, in order to ‘consume’ the grantor’s currently large transfer tax  exemption while that exemption is still available. The obvious benefits of a SLAT are the use of the donor’s available applicable exclusion amount (up to $11.7 million) for both the gift and if applicable the donor’s generation skipping transfer tax (GST). The transferred assets to a SLAT escape federal estate and GST taxation on the spouse’s death, including any appreciation of the transferred assets. In addition, the donor’s spouse can be given the right to receive all of the income generated by the SLAT assets, which means that even after the gift to the SLAT removes the transferred assets from both spouses’ estates during the marriage using a separate irrevocable trust, the married couple will continue to have access to the SLAT’s income for the balance of the beneficiary-spouse’s lifetime. However, some wealthy individuals may have already used their applicable exemption amount with lifetime gifts, causing a SLAT to not be an option. There are some complications associated with the use of SLAT though, which might deter the donor spouse from making a large lifetime gift to the SLAT such as: (i) navigating the mysterious and uncertain reciprocal trust doctrine; (ii) the prospect of a future divorce between the spouses; and (iii) the donor- spouse’s loss of access to the SLAT’s income after the death of the beneficiary-spouse.

QTIP Trust Alternative: While the funding of a lifetime QTIP Trust will not use the grantor’s available applicable exemption amount, unlike a SLAT, there are still some benefits that can be derived with a lifetime transfer of assets to a QTIP Trust for the donor’s spouse. With a QTIP Trust, the donor-spouse makes a gift to an irrevocable trust for their beneficiary-spouse that qualifies for the federal gift tax marital deduction and then formally makes a QTIP election on a Form 709 Federal Gift Tax Return. [IRC 2523.] Some benefits that can result from a lifetime SLAT include:

  • ‘Wait-and-See’ QTIP Election: The decision of whether the donor-spouse makes the QTIP election on a Form 709 Federal Gift Tax Return can be delayed until October 15, of 2022. This permits a wait-and-see approach to whether Congress reduces the donor’s applicable exemption amount, as is currently suggested in a couple of bills pending before Congress. Delaying the decision to make the QTIP marital deduction election provides some flexibility to the donor-spouse; if the QTIP election is not made, the trust becomes essentially a SLAT. [Note, however, that if the donor-spouse dies in the year of the gift of assets to the QTIP Trust, the gift tax return must be filed by the donor’s federal estate tax return deadline, which may be sooner than October 15, 2022.[IRC 6075(b)(3).]]
  • ‘All Income’ to Spouse Requirement: Unlike a SLAT, the beneficiary-spouse must receive all the income from the QTIP Trust in order to qualify for the unlimited federal gift tax marital deduction. Accordingly, the QTIP Trust functions much like a SLAT established for the donor’s spouse. Like a SLAT, the beneficiary-spouse’s access to  the QTIP Trust’s principal can be controlled by the QTIP trustee, or denied entirely to the beneficiary-spouse. This right to receive all QTIP Trust income presents a problem, however, if the spouses later divorce.
  • ‘Reverse’ QTIP Election and the GST Exemption: The donor-spouse can make a Reverse QTIP Election, such that the donor-spouse would become the transferor for GST tax purposes with regard to the ultimate distribution of assets from the QTIP Trust after the beneficiary-spouse’s death. [IRC 2652(a)(3).] Once made, this reverse QTIP election is irrevocable. If no reverse QTIP election is made, the beneficiary-spouse will be treated as the transferor to the remainder beneficiaries for GST tax purposes at his or her death (or as a result of a taxable lifetime transfer should the beneficiary-spouse release or transfer his/her income interest in the QTIP Trust. [IRC 2519.] The reverse QTIP election may be an attractive option for clients who need access to trust income during life, but who would like trust property to pass GST tax-free at the beneficiary-spouse’s death. Subject to the beneficiary-spouse’s right to all of the QTIP Trust income, the property held in the QTIP Trust can grow in a GST tax-exempt environment and be combined with other GST-exempt property at the beneficiary-spouse’s death.
  • No Portability of the Grantor’s GST Exemption: It is important to remember, too, that the GST tax applicable exemption amount (currently $11.7 million), unlike the federal estate and gift tax applicable exemption amount, is not subject to the portability on a spouse’s death. Consequently,  if the donor-spouse wants to preserve and use his or her currently large GST tax exemption, a Reverse QTIP election with regard to transfers to the QTIP Trust is one way to use that GST tax exemption now, before it is reduced or disappears.
  • Grantor Trust: Another concern with the use of a SLAT is that the trust is a grantor trust for income tax reporting purposes. [IRC 677.] Upon the beneficiary-spouse’s death, the continuing trust continues as a grantor trust for income tax reporting purposes, even after the beneficiary-spouse’s death, which means the donor-spouse continues to be liable for the income tax liability of the SLAT’s continuing trust.  Fortunately, the SLAT trustee can, from time to time, reimburse the donor-spouse for the continuing trust’s income tax liability. [Revenue Ruling 2004-64.] With a QTIP trust, even if it starts out as a grantor trust, by statute on the beneficiary-spouse’s death, the beneficiary-spouse is treated as the transferor of its assets, so that the QTIP Trust would cease to be treated as a grantor trust on the beneficiary-spouse’s death, which means no residual income tax liability for the donor-spouse. [A QTIP Trust is not mentioned in Revenue Ruling 2004-64 with regard to as its grantor trust status.]
  • Creditors: The transfer of assets to a QTIP Trust for a spouse’s benefit removes the assets from the reach of the donor-spouse’s creditors and it also protects the assets for the beneficiary-spouse, just like a SLAT. While the creditors of the beneficiary-spouse can attack that spouse’s income interest in the Trust, the QTIP Trust’s principal would be protected from those creditor claims.
  • Donor-Spouse Better Protected from Creditors: One of the drawbacks to a SLAT is dealing with the scenario of the beneficiary-spouse’s death while the donor is still alive, after which the donor-spouse will no longer have indirect access to the income generated by the SLAT. Several suggestions have been floated to enable the donor-spouse to indirectly benefit from the SLAT that he/she created after the death of the beneficiary-spouse, such as giving the beneficiary-spouse a testamentary power of appointment to add the donor-spouse as a contingent beneficiary to the continuing trust that he/she initially created. However,  due to the relation back doctrine associated with powers of appointment created under a trust, the fear is that the donor-spouse would then be treated as having created a self-settled irrevocable trust that would either expose the continuing trust’s assets to the creditors of the donor-spouse (who is now trust beneficiary), or worse yet, cause the value of the SLAT’s assets to be taxed in the donor-spouse’s taxable estate.

Regulations: Unlike a SLAT, with a QTIP Trust it is possible to give to the donor-spouse an interest in the QTIP Trust’s continuing trust after the beneficiary-spouse’s death, if the beneficiary-spouse predeceases the donor-spouse. The marital deduction Regulations permit the donor-spouse to create a lifetime QTIP Trust in which the donor-spouse retains a contingent income interest if the beneficiary-spouse  predeceases the donor-spouse. After the beneficiary-spouse’s death, that deceased spouse will be treated as the transferor of the QTIP Trust’s assets. Consequently, the original donor-spouse’s contingent interest in the QTIP Trust will not be treated as a retained interest under IRC 2036. As a result, the donor-spouse will not actually possess a contingent beneficial interest in the QTIP Trust property, shielding the continuing trust’s assets from the donor-spouse’s creditor claims.  In short, the donor-spouse is not treated as having retained an interest in the QTIP Trust, or its continuing trust after the beneficiary-spouse’s death. [IRC 2523(f)(1)(B); Treasury Regulation 25.2523(f)-1(d) and (f).]

Michigan Trust Code: The Michigan Trust Code also provides that the donor-spouse, who later becomes an income beneficiary of the QTIP Trust’s continuing trust that he/she created, after the death of their spouse, will not be considered as the trust’s settlor with respect to the retained interest in the continuing Trust for creditor protection purposes. [MCL 700.7506(4)(b).]

Conclusion: The QTIP Trust provides many of the same benefits as a SLAT, other than the current use of the donor-spouse’s  available applicable exclusion amount. The ‘wait-and-see’ approach to the donor-spouse filing the election to treat the trust as a QTIP Trust provides some flexibility that many are looking for this year with the uncertainty if Congress lowers an individual’s $11.7 million transfer tax exemption to a much lower amount, like $6.0 million or even $3.5 million. A QTIP Trust also affords some benefits to the donor-spouse especially after the death of the beneficiary-spouse that are not available if a SLAT were used with lifetime gifts, e.g. a reverse QTIP election for using the donor-spouse’s GST exemption; not classified as a grantor trust for income tax reporting after the beneficiary-spouse’s death; and the donor-spouse’s right to retain an income interest in the QTIP Trust’s continuing trust after the beneficiary-spouse’s death. In sum, while the QTIP Trust will not use the donor’s available applicable exclusion amount which is the primary benefit of a SLAT, there are still plenty of benefits that can be derived if a lifetime QTIP Trust is created.