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Drafting the Quintessential QTIP
hat special provisions can improve a QTIP these days? There have long been numerous QTIP variations and strategies to choose from, but creative minds are always pushing the envelope of QTIP science. Some of these ideas have been debunked - the surviving spouse's purchase of the QTIP's remainder interest is a case in point.
Other concepts, such as the Clayton "contingency provision" (under which executors have discretion in funding the QTIP), have completed their journey through the courts and have become part of the QTIP repertoire. And, in the wake of the Taxpayer Relief Act of 1997, there are new QTIP angles to consider. Let's examine several aspects of the state-of-the-art QTIP.
Marital Teamwork
Since 1982, transfer between spouses have not been taxable. As a result, the marital team of husband and wife can run downfield on a figurative taxpayer's gridiron, avoiding grey-suited tax authorities by lateraling assets back and forth.
Gift splitting, for purposes of the annual gift tax exclusion, also acknowledges the marital team - since spouses have the ability to apportion marital assets as the see fit, they can divide assets to allow each spouse to apply the annual exclusion. Coordination of assets is especially important for transfer tax purposes over two transfers.
The Deep Pass
One spouse runs the length of the field and the other passes the entire estate in one long pass. Touchdown. Perhaps it is human nature to rely entirely on the marital deduction to avoid transfer taxation at the death of the first spouse. It's simple. It works. But it isn't always the best plan.
Estate planners understand that the first spouse's unified credit is too valuable to waste. The consequence of over-relying on the marital deduction for the first transfer may be unnecessary taxation at the second transfer, i.e., the death of the second spouse.
The A/B Plan
The focal point of the modern marital estate plan is a two-trust combination. One trust (the credit shelter trust) takes advantage of the decedent spouse's unified credit, while the other trust qualifies for the marital deduction.
I Am Joe's QTIP
Who am I?
While an outright gift to the surviving spouse would qualify for the marital deduction, ERTA '81 also made it possible to provide a spouse with a terminable interest, i.e., an income interest for life, which qualifies for the marital deduction if requirements are met.
Where am I from?
Like most modern documents I can be reproduced from a form book, generated on a word processor, or constructed with computer assistance using interactive software. Without any argument, all of these methods get the job done as far as establishing the standard, highly effective QTIP-plus-credit-shelter arrangement, a.k.a. the two-trust, or A/B approach that is universally followed.
Why am I so handsome?
What makes a basic "no-frills" QTIP trust valuable in the first place? It saves tax. It retains flexibility by allowing invasions of principal for selected purposes. And it accomplishes a useful distribution of assets - providing the surviving spouse an income interest with the remainder to others, yet qualifying the transfer for the marital deduction.
Trust Advantages
When QTIP advantages are listed on paper, many of them actually relate to the fundamental attributes of a professionally administered trust - investment supervision, impartial administration, asset protection from creditors, etc.
A Game Plan beyond the Credit Shelter
There's more to estate tax planning than the credit shelter trust. Certainly, the unified credit enjoys special status because it is a limited resource and if you don't use it, you lose it. However, it is certainly not the only advantage that should be exploited by each spouse's separate estate.
The GST Exemption
Each spouse also has a $1 million exemption from the generation-skipping transfer tax. Suppose an estate plan utilizes a formula for funding trusts. For example, in 1999, an estate might fund a credit shelter/GST trust with $650,000, based on the available unified credit (a.k.a. applicable credit amount). This leaves %350,000 of unused GST exemption. The estate would have to make a reverse QTIP election for GST purposes.
Example: A trust designed to take advantage of the GST exemption can follow the QTIP format. If the QTIP election is made, the marital deduction applies and the trust assets will be included in the surviving spouse's estate. To include the assets in the decedent spouse's estate for purposes of using the GST exemption, a reverse QTIP election must be made under §2631. However, since this election must be made to an undivided QTIP trusts, it is necessary to establish two separate QTIP trusts, one of which can then be used in conjunction with the reverse QTIP election. A provision enabling the trustee to sever a QTIP trust may be useful.
Progressive Tax Schedule
Before the estate and gift tax maxis out at 55% for amounts exceeding $3 million, amounts are taxed at lower rate schedules. In some estate, having the first spouse to die pay some transfer taxes may result in less total tax over the course of two transfers.
Example: Assuming the unified credit has been exhausted and no other credits apply, an estate of $6 million or more can save $359,200 of estate tax over the course of two transfers if $3 million is taxed in the estate of each spouse. The downside, obviously, is having to pay tax sooner. This is less significant where the surviving spouse is in failing health and is not expected to survive the first spouse by very long. In that case, it is worth paying some tax on the first spouse's estate to save up to $359,200.
Business Exclusion
The same assets that qualify for the business exclusion in the estate of the first spouse to die may qualify for the business exclusion in the estate of the surviving spouse.3 While the use of the new business exclusion does not interfere with the marital deduction, the marital deduction formula may require adjustments to include sufficient assets to cover the business exclusion.
Conservation Easement
Each spouse cannot claim a conservation easement on the exact same parcel of land. Obviously, once a permanent conservation easement is placed on the land, heirs taking possession cannot place additional conservation easements on the same land. However, the conservation easement is relatively limited, reaching its top limit of $500,000 in 2002. So, assuming all conservation easement requirements are met under §2031(c), a couple with a large parcel of qualifying land may want to place separate portions of the land in each spouse's estate and let each take advantage of the $500,000 benefit.
Give Me Shelter
A credit shelter trust has been funded and the assets are safe and sound in a cozy trust arrangement. But many issues remain to be resolved.
A Powerful Spouse: Howard refers to his wife, Ruth, as "She who must be obeyed." His will establishes a credit shelter trust for his sons. However, Ruth is given a lifetime income interest as well as a variety of powers over the assets.
Appointment Power
A spouse can have power to appoint the principal of the credit shelter trust to the children/remaindermen with certain limitations. Appointment of assets to children the spouse is legally obligated to support may constitute a taxable gift. A gift may also result to the extent that the spouse's present income interest in the trust is reduced by the transfer.
Invasion Power
The spouse's ability to invade the corpus of the trust can be limited by the discretion of the trustee. If the spouse is serving as trustee or co-trustee and has unbridled power to invade the principal, the power is not limited by an ascertainable standard and the spouse will have a general power in the asset for tax purposes. In several jurisdictions, state laws also prohibit a trustee to use a power of appointment to benefit himself or herself.
Comments: Invasion powers can also be limited by giving the spouse a general power that is limited to $5,000 or 5% of the trust. Such a power will not result in a gift if the power lapses. Note also that the sequence of invasion should also be considered. It makes sense to have the surviving spouse invade and exhaust the QTIP assets first because they, unlike the credit shelter assets, will be included in the spouse's gross estate.
Trustee Power
As trustee, Ruth would certainly have more "hands on" control over the assets, but a number of caveats must be noted. Too much power and the spouse will have a general power for tax purposes, not to mention the family conflicts that may arise.
QTIP Variations
As with the credit shelter trust, the surviving spouse may be granted various powers over the QTIP trust. Will income from the trust be sufficient? An invasion power can be carefully drafted to allow trust principal to be used for a spouse's "health, support, education, and maintenance." Those who stray from the specific language of §2041 with subjective terms like "comfort" or "happiness" invite trouble.
Choice of Fiduciaries
An impartial fiduciary is particularly relevant in a second-marriage situation where the trust beneficiaries are children of a previous marriage. In that circumstance, the spouse serving as sole trustee may have a conflict of interest. And, as a general rule, trusts don'' get involved in litigation because a corporate fiduciary was too impartial - it is frequently just he mere perception of a family member's bias, inexperience, or failure to communicate that brings people to court.
Other Powers
While it may not always be suitable to name the surviving spouse as the trustee, it is possible to give the spouse power to change the trustee. However, this can constitute a general power of appointment over trust assets if drafted too broadly.
Flexibility, Clayton Style
We have seen how various spousal powers can add flexibility to trusts as they are carried out. On a macro level, the overall alignment of trusts may also need adjustment as circumstances change.
Partial QTIP Election
For example, an executor can make a partial QTIP election to adjust the portion of the estate QTIP election to adjust the portion of the estate that will qualify for the marital deduction. However, the assets remain in place, subject to the same trust terms.
Disclaimer
A surviving spouse can also disclaim QTIP assets. However, the disclaimer would have to be timely and meet all requirements. Another potential problem is the prerequisite that the surviving spouse remain willing to execute the disclaimer.
Clayton Arrives
A powerful new tool, named for the 1992 case of Clayton v. Commissioner, allows the executor to participate earlier in the process by exercising discretion on the extent to which the QTIP trust is funded. It has taken a long line of cases being fought toward success in three different appellate circuits to convince the IRS to concede the issue.
Putting It All Together
Division of Assets
There are so many strategies, yet an estate only has so many assets to go around. Coordination is needed. This brings us back to the marital team. While it's nice to plan for the use of various tax benefits each spouse's estate, an obvious prerequisite is that each spouse must have sufficient assets to apply to each of these techniques. In this regard, we must fight the influence of stereotypes. The husband may not die first. An older, infirm spouse may survive a younger, healthy spouse.
QTIP & CRT
A charitable remainder trust (CRT) can be coordinated with a QTIP to eliminate estate tax in the decedent spouse's estate. The decendent's estate won't get the estate tax charitable deduction for the remainder interest, but the entire trust qualifies for the marital deduction. Although the trust is then included in the surviving spouse's estate, it will qualify for a charitable deduction.
Retirement Assets
The surviving spouse may already have an interest in the decedent's retirement plan. Moreover, the use of retirement assets to fund QTIPs must begin by examining the plan or IRA to see what payment options are permitted. The ensuring trust will need to meet QATIP requirements as well as ERISA minimum distribution requirements.
Marital Deduction Formulas
In funding QTIPs, the marital deduction formula will depend on whether any estate tax is to be paid when the first spouse dies, whether a fractional share or a pecuniary formula is used, and which assets are available in light of the overall estate plan.
That Quintessential QTIP
Although QTIPs were legislatively approved a mere 17 years ago, they have become a fundamental estate-planning building block for every married couple with a potentially taxable estate. Which QTIP approach is the best? There are many excellent provisions to empower the surviving spouse or other heirs and guide assets in the future. On the other hand, the longer and more involved any document, the more time needed to interpret it. There's a lot to be said for keeping things simple.
There is also a concern that arrangements attract people with tax savings and fill a vacuum that exists when a grantor has not thought the process through. Perhaps the answer is to avoid indiscriminately selecting every possible QTIP provision, but to design a game plan for the use of assets based on the grantor's intentions, judiciously select those provisions that apply, and then particularize the terms to address the actual circumstances you are dealing with.
References
1
Matter of Olsten, New York Journal, July 8, 1993, p. 28, was a Surrogate Court case that involved a QTIP trust worth $53 million. In 1995, when the trust was worth $75 million, it was proposed that the surviving spouse purchase the remainder interest of the QTIP using a promissory note. Once the spouse got the QTIP assets, she could sell them to satisfy the note. In the process, the remainder interest, which would have been taxed in the surviving spouse's estate, would be removed from the estate without incurring transfer tax. As hopeful as this was, a fair amount of skepticism is warranted whenever tax alchemists propose turning a taxable interest worth $50 million (i.e., 66.6% of the trust's present value) into a paid debt that escapes taxation. This year, the remainder-purchase approach was repudiated by Rev. Rul. 98-8, 1998-7, IRB 24, in which the IRS confirmed that such a maneuver results in a disposal of assets...a taxable transfer under §2519.
2
Under §2056(b)(7) all income from a QTIP must be paid to the surviving spouse at least annually and no one may appoint any portion of the trust to any person other than the surviving spouse.
3
Hodgman and Stetter, Drafting for the marital deduction in light of the new family-owned business exclusion, 25 EP 5, p. 229 (June, 1998). However, the authors note the uncertainty that exists on whether §2033A excludes a particular asset from the estate. Hopefully, the statute will be interpreted to exclude value in general, making it irrelevant which assets are allocated to which trust. This issue will warrant ongoing supervision.
4
New §§1014(a)(4), 2031(c), and 2032A(c)(18), added by §508 of the Taxpayer Relief Act of 1997. Conservation easements after TRA '97, The Estate Analyst (Feb., 1998).
5
Tiernan, What powers over a credit shelter thrust can the spouse possess?, 23 EP 9, p. 424 (Nov., 1996).
6
IRC §§2041 and 2514. Tiernan, How to draft invasion clauses for marital and credit shelter trusts, 25 EP 6, p. 259(July, 1998).
7
Clayton v. Comm'r., 976 F2d 1486 (5th Cir., 1992); Estate of Robertson v. Comm'r., 15 F3d 779 (8th Cir. 1994); Estate of Spencer v. Comm'r., 43 F2d 226 (6th Cir. 1995); Estate of Clack, 106TC 131(1996); T.D. 8714, 62 Fed. Reg. 7156 (Feb. 18, 1997). For discussion, see, Newman and Kalter, New regulations approve use of contingent QTIPs, 24 EP 6, p. 265 (July, 1997); and, Blattmachr and Zaritsky, Coping with the new Clayton QTIP regulations, 136 T&E 6, p. 41 (May, 1997).
8
Talavera, Mobley, and Johnson, What are a spouse's rights in retirement plans and IRAs?, 23 EP 3, p. 109 (march, 1996); Moore, Interaction of the estate tax marital deduction and qualified plan and IRA benefits, 23 EP 2, p. 86 (Feb., 1996); and Holding, Getting QTIP treatment for IRAs and qualified retirement plans, 131 T&E 2, p. 26 (Feb., 1992).
9
Nudelman and Panos, Choosing the most appropriate marital deduction formula clause, 22 EP 6, p. 256 (July, 1996).
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