Qualified Terminal Interest Property (QTIP) Trust

A friend died two years ago. He had handed over assets to his wife during their marriage and always assumed they would pass on to their three children. I know he did this to take care of her, but I also know that he thought that his children would ultimately inherit the estate. She remarried this year and now she is including the new husband’s children in the estate. This greatly dilutes what his three children will receive. It has made me take a hard look at my estate planning. Someone told me to look into getting a Q-tip. Are they joking?

Well, we assume they do not mean a cotton swab. Actually, they gave you good advice and a drink and dinner are in order.

Life is full of uncertainties such as which spouse will outlive the other, remarriage, changes in tax law, etc. In the usual situation a husband and wife simply leave their property to each other. So, whichever the surviving spouse gets all the assets and then if he or she re-marries; that's how problems happen. It's even possible that the children of the first marriage could end up with nothing at all in some cases.

This seems unfair and a QTIP (or Q-TIP) trust is a way to ensure this doesn't happen. It serves as a way for you to manage that uncertainty. Additionally, not only does it provide for your surviving spouse and children after your death, but it also gives flexibility to your executor to maximize your federal estate tax savings.

QTIP is an acronym for Qualified Terminal Interest Property Trust. It is provided for specifically by statute (IRC Section 2056). One of the reasons a QTIP is used is as a way for a spouse to leave money for the care of their current husband/wife and insure that his/her children will eventually inherit the balance of the estate. This will help resolve the quandary you describe in your question regarding your friend’s intentions.

Let's look at what we mean by qualified and terminal. "Qualified" refers to property that is eligible for the marital deduction. That means it can pass to the surviving spouse without being taxed when the first spouse dies. "Terminal" means the surviving spouse receives the income interest during his/her lifetime and that interest terminates at his/her death.

A QTIP requires that:

1. The grantor passes the property to the spouse.
2. The surviving spouse is entitled to all of the income (no sharing with another beneficiary) during his/her lifetime.
3. The income the property earns is paid at least once a year.
4. The surviving spouse must have complete control over non-income producing property. They must have the right to make that property productive.

A QTIP trust is an arrangement that is more restrictive than the typical marital trust. In typical marital trust arrangements (or a will for that matter), the marital portion of the trust is fully accessible by the surviving spouse. Until Congress established the QTIP trust option, it was necessary to give this kind of full control to the second spouse in order for the assets to qualify for the marital deduction. Perhaps due to the reality of so many blended families in modern society, Congress acted to allow the QTIP option.

In a QTIP trust, there is limited access to the trust assets for the surviving spouse. Your spouse may receive income from the trust, but he/she cannot decide on the disposition of the trust assets and cannot withdraw principal from the trust. Upon the death of your spouse, the trust is distributed according to your specifications.

The restrictive ownership provisions of a QTIP trust are particularly useful for second marriages since you may want to ensure that the amount held in the trust will ultimately pass to your children or family and not the children or family of a second spouse.

A husband or wife can make unlimited marital gifts to his or her spouse. If he (assuming husband dies first) makes them into a QTIP trust, the assets qualify for the marital deduction for gift and estate tax purposes. The wife is provided for from the income from the trust, and the trust can distribute principal. The grantor may either specifically name his children or give his spouse a limited power to allocate the remainder among a class of beneficiaries consisting of his children. At the husband’s death, his estate takes a marital deduction for the QTIP trust and thus it's not taxed then. However, the IRS has to collect at some point, so at the wife’s death, the QTIP trust is included in her estate and potentially taxed then. Her estate generally will be able to recover, from the QTIP trust, estate taxes (if any) due to the inclusion of the additional assets from the QTIP trust in her estate. Again, the assets in the QTIP pass in accordance with the husband’s (first spouses') instructions.

There can be estate tax disadvantages in some cases (primarily due to the first deceased spouse not fully using his or her personal estate tax exemption). Therefore, often the trust is written in such a way so that the executor can choose to make a "QTIP election" or not depending on the current value of the assets; current estate tax limits, etc. Often splitting assets between two trusts (one being a QTIP) makes sense.

In any event, there is no doubt that a QTIP trust can be an important part of your estate plan if you want flexibility in the timing of estate tax payments (not until death of second spouse) AND the assurance that assets will remain in your family.

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