A half-dozen uses for a QTIP. (qualified terminable interest property)by Sherman, W. Richard
Since 1982, married taxpayers have had the ability to "have their cake and eat it, too" when disposing of property in certain gratuitous transfers. The "cake" that taxpayers can have is the deferral of gift and estate taxes on interspousal gifts and bequests. The Economic Recovery Tax Act of 1981 (ERTA) provided this benefit by way of an unlimited marital deduction for gifts and bequests to spouses. These transfers can be effected .tax free, with the tax consequences postponed until a subsequent property disposition by the recipient spouse through gift, sale, or death. A deduction for interspousal transfers is itself not new, having been created shortly after World War II to equalize the tax treatment of interspousal transfers in separate property., (common law) states with those in community property states. ERTA brought about an elimination of many limitations that existed on the marital deduction in terms of both the amount and types of transfers that qualify.
While the marital deduction has always been a welcomed opportunity in gift and estate planning, it is not without costs. Perhaps the most painful difficultv for many donors/testators was the loss of control over property given to a spouse. To take advantage of the marital deduction, pre-1981 versions of the IRC required that the donee/beneficiary of a marital gift/bequest had to actualIy, receive ownership of the property and an absolute right to do with it as the donee wished. Such an arrangement is not always what the donor/testator has in mind. It is in this regard that the 1981 change appears to be so revolutionary. The donor/testator is now permitted to determine the ultimate disposition of property while still having the transfer qualify for an unlimited marital deduction. The exception provided by IRC Sec. 2056(b)(7) (devises and bequests) and by Sec. 2523(f) (gifts) is for "qualified terminable interest property," or, as it is commonly denoted, QTIP.
This article describes a few of the common circumstances in which a QTIP can provide a tax-beneficial vehicle for effecting interspousal transfers. The focus is on testamentary gifts to spouses, the estate tax, and Sec. 2056. However, except where noted, the points made are equally applicable to lifetime interspousal gifts and the gift tax provisions under Sec. 2523, for the QTIP is equally attractive as a vehicle for intervivos transfers.
SETTING THE STAGE: GIFT AND ESTATE PLANNING
For most planning situations, in addition to the tension between what the donor/testator wants to do with the income interest property. and where the donor wants to see the principal go, there is often a tension between what the donor wants to do with these assets and the tax consequences of transfer. This is where the marital deduction is so valuable in that it accomplishes, at least to some extent, the donor's wish to benefit the surviving spouse while at the same time assuring the deferral of tax until death of that spouse.
As was noted, for a property transfer to qualify for the marital deduction, the recipient spouse must be given essentially unrestricted ownership. If the ownership is something less than full and complete or, in the words of the IRC, "where, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency, an interest passing to the surviving spouse will terminate or fail, it will be a terminable interest" and not qualify as tax free. The rationale for this general rule is simple: if this were not the case and a terminable interest were allowed to pass tax free under the marital deduction, it would be possible to escape taxation altogether by having the interest conveniently "terminated" prior to or at the spouse's death. With the interest terminated, its value would not be included in the surviving spouse's estate.
QTIPs are an exception to this general proposition only because they cannot escape taxation upon subsequent transfer by the recipient spouse. Except through consumption, disposition of qualified terminable interest property will result in a taxable gratuitous transfer. If made during the holder's lifetime, the tax consequences to the recipient spouse will be based upon the value of the entire property., even though the special testamentary power of appointment over the principal and limiting her choices to specified beneficiaries, a listing that would be carefully drawn so as not to include any future spouse.
Use #3: Family Feud
Family conflicts are not the monopoly of remarriages. The interests of many surviving spouses are often at odds with those of their own children (that is, children of D and S). In these cases, the QTIP provides an excellent vehicle to minimize the potential for conflict by giving the surviving spouse a qualifying life interest while leaving the principal to children of the marriage. Thus, both sides can benefit from D's estate planning and some battles can be avoided.
If D wants to provide S with additional "leverage" over the children, he can do so by giving S a special testamentary power of appointment. For example, S might be given the power to choose which children will share in the remainder interest and the amount or proportion of principal each wiII receive under her will. This power of appointment wiII not cause the QTIP to fail since it is not a power exercisable during S's lifetime.
There is still the potential for a familial conflict of interests that might be caused by the QTIP itself, namely, whether the election of QTIP status should be made in the first place. It bears repeating that even though an otherwise qualifying interest may have been drafted, the creation of a QTIP requires an affirmative election by D's fiduciary. The election is by no means an assured conclusion, nor should it be. In some cases, the QTIP is simply not desirable. Whether the election is appropriate depends on many fact-sensitive issues and upon the perspective of each particular beneficiary. What "'works" for the surviving spouse may not "work" for the children.
As a general rule, the surviving spouse is almost always in favor of the QTIP election. The reason is simple: if the election is made, the unlimited marital deduction will allow the property to pass to her tax free. S will benefit from the income-earning potential of the entire property unreduced by taxes. As to future tax repercussions, they are not of immediate importance to S and will require additional estate planning at some later date. S is often quite content to "cross that bridge" when she gets to it.
On the other hand, the children of D and S may not be so keen on the executor making the QTIP election. While no taxes are due upon D's death, the full value of the remainder interest at the time of S's death must be included in her estate (this is the quid pro quo for allowance of the marital deduction). Given the potential for appreciation in value during S's remaining life, this could lead to increased taxes that the children might rather avoid by simply paying taxes at D's demise and controlling their inheritance shares immediately. To further magnify the children's potential tax woes is the fact that the QTIP will be taxed at S's highest marginal tax rate, since the tax liability is calculated on the basis of the estate tax due on S's estate with the QTIP included versus tax due on the estate without it.
Even though there is no simple answer in these circumstances, the executor or administrator must resolve the conflict. Suffice it to say that it may take more than a mere mathematical calculation to convince all of D's heirs about the soundness of the eventual decision. One solution would be to have an express direction in D's will that the QTIP election should be made. While this would effectively cut off this debate between D's widow and his children, it also would negate the post-mortem flexibillW which makes the QTIP an attractive vehicle.
Use #4: The "Dumb" Spouse
Upon D's death, S is often in an extremely vulnerable position. It is not just that S no longer has D around to provide love, support, guidance, and companionship, for the situation is complicated by the fact that S may well have more assets at her disposal than she ever had before in her life. Whether S is familiar with the ways of the world or has been sheltered from the realities of the day-to-day details of personal finances, she is a likely candidate for a "bad deal." S is not an inherently "dumb" spouse, but she is put in a position with the opportunity to make bad decisions that appear to be "dumb" from the perspective of other interested parties.
At the risk of further maligning an already much-maligned industry, take as an example the case of a disreputable nursing home. Assume that D had left his entire estate as an outright bequest to S. Despite the support from her children, S feels alone and is concemed about the care she will need during the remaining years of her life. Enter the slick sales representative from the local nursing home who offers a guaranteed place to stay, well-balanced meals, and top-notch medical care in exchange for the right to S's assets when she dies. This sounds like a good deal to S. Indeed, it may well be a good deal all around, but it also means that S's children (and other heirs) will get nothing. And, this is so even if D had left all his assets to S with the clear intention and understanding that S would bequeath them to their children.
What protection can D offer to these intended beneficiaries and still assure the tax-deferral benefits of the marital deduction? As a common first step, D could transfer the property in trust for S instead of making an outright gift or bequest. Having the property under the management of a fiduciary goes a long way towards eliminating many of the more flagrant cases of "throwing away" the assets. This is the reason why in most QTIP situations a trust is created to hold the qualifying property.
Another fairly common device used when a husband or wife has doubts about their partner's ability to manage assets is to restrict use of the property with a "spendthrift clause." Such a clause bars the use of the property to pay debts of the beneficiary, in effect putting the assets beyond the reach of S's creditors. As further insurance against the intentional or unintentional wasting of assets by S, a spendthrift clause would seem to be a logical addition to any QTIP provision, even if the QTIP is to be held in trust. Given the requirement that S be entitled to all the income from the property for life, the use of a spendthrift clause on property designated for QTIP treatment will be permitted only if it does not apply to S's income interest. In light of this restriction, a spendthrift clause would seem to be superfluous in the QTIP setting since D can already put the corpus of the trust beyond the reach of S's creditors by designating the beneficiaries of the remainder interest. Simply stated, creditors, including the disreputable nursing home, cannot get something from S that S does not have-- and S does not have the right to the principal. The QTIP provision, then, can protect the surviving spouse against her own bad judgment.
Use #5: The Sick Spouse
There is a recurring theme in each of the uses discussed thus far. D wants to provide for S but also wants to protect the property for the benefit of someone else, usually D's children. One of the greatest dangers to the remaindermen is dissipation of the assets by S, the holder of the life estate. This diminution could be out of spite (the "wicked" step-parent or the family feud), love for another (the "new" spouse), or from a basic lack of business acumen (the "dumb" spouse). Or it could be due to circumstances beyond anyone's control. Such is the case of extended geriatric life and medical care.
With the costs of medical care rising in recent years at a rate much greater than consumer prices, a long convalescence is one of the most frightening prospects and expensive situations anyone can face. In terms of estate planning, the costs of extended medical care can destroy the best laid plans that a donor/ testator may make. Assume, for example, that D and S are happily married with no prior divorces, have devoted, loving, and supportive children, are both well educated and versed in the ways of the world, and have been smart (or lucky) enough to avoid any of the other scenarios previously depicted as being ripe for use of a QTIP. Consequently, D sees no reason to leave S with anything less than full control of all the assets, perhaps as an outright bequest or maybe in a trust for which S has a general power of appointment.(3) D dies, and S inherits everything free of estate taxation as a result of the unlimited marital deduction.(4 )S then gets sick, expending, first, the current income stream to cover the medical bills. But S is still sick and is forced to consume principal. It is certainly not S's intent, yet she is eating into the children's future inheritance.
What can be done? S needs help from the federal or state government in the form of medical benefits; but eligibility for this assistance, such as Supplemental Security Income (SSI) or Medicaid, is usually dependent upon a showing of financial need. Ks the recipient of all of D's property, S will not qualify for these benefits until nearly all that D had left her is gone. This is a situation in which a QTIP may provide some relief.
In what he calls a "vulture's approach to estate planning," one author has suggested that a good plan would be to leave property in a QTIP trust. Powers that the trustee may have to invade the corpus for S's benefit, if any had been granted in D's will, should be narrowly limited so as not to allow payment for extended medical treatment. If properly drafted, this would result in having only S's income interest in the QTIP included in the determination of financial need, and S should be able to qualify for government assistance. S would get the medical care she needs and the remainder interest would be left intact.
Although it was probably never envisioned by its Congressional creators for such a use, the QTIP would be an appropriate vehicle since its raison d'etre is restriction of S's access to the principal. This type of planning is not without risk. While it works in the current environment of federal and state regulation, this environment could change in response to the need for reform in Medicaid and other assistance programs. What might then result is indeed a worst-case scenario: S would be denied federal or state assistance due to the perceived abuse of this estate planning technique and yet would have no access to the assets "locked up" in the QTIP trust. It is a strategy that might backfire and should only be attempted after careful consideration of the attendant risks.
Use #6: The Reverse QTIP
A gift and estate plan will typically involve at least some transfers of property that will "skip generations," going, for example, from D to his grandchildren or great-grandchildren. Secs. 2601 and 2602 impose a separate tax in addition to any gift or estate tax on such transfers. Since 1987, decedents have had available a $1 million exemption from taxation on generation skipping transfers (GST). The planner, then, has two means of significantly reducing estate tax liability: the unified gift and estate tax credit (that now is equivalent to a $600,000 exemption) and the GST tax exemption. The trick is to get the most from both.
As far as the credit is concerned, a useful strategy has been to create a two-part estate. One part is designed to absorb any remaining unified credit that is available at D's death, with the consequence that these assets would pass completely free from taxes on either D's or S's estate. The second part would be set up to qualify for the unlimited marital deduction, thereby deferring tax liability until S's subsequent transfer of the property by gift or bequest. As a result of this planning, the total tax on the two estates (i.e., D's and S's) would be minimized since, by taking advantage of the exemption equivalent available to D, there would be little danger of "overloading" S's estate.
In pre-ERTA days, two trusts were often used to accomplish this, with the amount that would go into the so-called "credit shelter" and "marital" trusts being determined by a formula. Under the QTIP provisions, even greater flexibility now exists for planning. Since qualification for the marital deduction by way of the QTIP depends on the executor's election for that treatment, the executor can decide how much, if any, of the property designed to qualify. as QTIP will be used for this purpose and how much will be used to take advantage of the (unused) unified estate and gift tax credit. This flexibility is enhanced by the executor's ability to make a "partial" election, designating certain property as QTIP while letting other qualified property pass outside the marital deduction. As a result, this common two-part estate strategy could be accomplished by way of a marital and a QTIP trust, two QTIPable trusts (only one of which would be elected), or one QTIP trust that would be only partially elected.
The added advantage of using a QTIPable trust (or trusts) is the opportunity available to the electing fiduciary of having a "second look" at the now-deceased testator's estate plans. Since the election is made only after D has died, much of the uncertainty that existed when the will was originally drafted will have disappeared. The executor will know the actual value and composition of D's estate and the amount of unified credit still available. As a result, with his ability to elect either partial or complete QTIP status, the fiduciary can exercise some hindsight, however limited, before making the final decision on how the assets should be divided among the various estate components.
The additional element of a possibly unused or under-utilized GST exemption introduces a new variable into the equation, but one that the QTIP is able to accommodate quite easily. As stated above, this exemption enables each taxpayer to shield $1 million of generation skipping transfers from the GST tax. Both D and S get their own $1 million exemption, but it is not transferable. Therefore, whatever amount of GST exemption has not been used at D's death is lost forever. Increasing the chances that D will die with an under-utilized exemption is the general rule that the QTIP, which passes to S under the marital deduction before it "skips a generation" to the remaindermen, is not considered to have been transferred by D to the remaindermen. Instead, it is treated as a GST by S on her death, offset only by S's own $1 million exemption.
There is a way out of this potentially missed opportunity: the "reverse" QTIP election under IRC Sec. 2652(a)(3). By using this special election, QTIPs will be treated (for GST characterization purposes only) as having passed from D to the remaindermen. This election will not disqualify the property from the unlimited marital deduction, and will enable D's or S's estate to take fuller advantage of any unused GST exemption. There is one drawback. The "reverse" QTIP election is an all or nothing proposition--it cannot be made for only a portion of a particular QTIP. Here things can become quite complirated for the estate planner who is juggling three elements: D the amount necessary to fully absorb the unified credit; 2) the amount to apply towards the GST exemption; and 3) the amount (possibly the residual) that will be taken as the marital deduction. One vehicle that has been suggested to maneuver effectively through this area is the "tripartite will." Instead of using a two-part estate plan consisting of a credit shelter trust and a marital trust, the tripartite will creates three trusts: a credit shelter, a GST exemption trust, and a marital trust.
While any combination of these can be designed as a straight pecuniary or formula trust, the flexibility afforded by the QTIP would suggest that provisions be made in planning D's estate for the establishment of three potentially QTIPable trusts. The first would not be elected, either completely or partially, for QTIP treatment and, thus, would intentionally not qualify for the marital deduction to take advantage of any unused gift and estate tax credit. The second would be elected as a QTIP for purposes of the marital deduction, but would be subject to the "reverse" QTIP election to take full advantage of D's unused GST exemption, once again noting that this election must be made for the entire property in the trust. Finally, the third trust would be elected as a QTIP and be designed to take up the balance of D's estate and qualify for the marital deduction's deferral of tax.
QTIP RULES ARE INTENDED TO PROTECT AND PROVIDE
Although not every testator will fall into one of the half-dozen categories discussed above for use of a QTIP, it should be clear that many opportunities are available for creative planning. Compliance with the specific statutory requirements is essential. Yet, that should be no bar to developing lifetime and death-time plans for interspousal giving that maximize flexibility while minimizing taxes. The QTIP rules were added to the IRC to provide a tax-advantaged means of carefully providing for family financial obligations. Every married individual whose estate rises above the level provided by the unified credit would do well to explore the possibility of applying the QTIP exception in his or her gift and estate plans.
The QTIP is an outstanding planning tool that allows multiple options. In fact, its flexibility extends to full, partial, or no election at all. This adaptability to facts and circumstances that could not be known at the time of its original drafting makes the QTIP a truly unique and valuable part of the estate planner's tool kit.
1. The $10,000 donee annual exclusion under Sec. 2503(b) is available for life interest and, as a consequence, that amount can pass tax free. However, gifts of the principal or remainder interest do not qualify for this exclusion.
2. For the reader who desires a more detailed consideration of the statutory QTIP requirements, see, for example, B.K. Benesh, G.A. Carnes, and T.E. Englebrecht, "Planning for Effectively Using QTIPs," The Tax Advisor (August 1990) pp. 500-11; and A.J. Golden, "QTIPS and Other Things Not to Stick in Your Ear,"NYU Institute on Federal Taxation Annual 47 ( 1989 ), Sec. 19.
3. Such a bequest, with property subject to S's general power of appointment, would qualify not as a QTIP but as another exception to the terminable interest rule under Sec. 2056(b)(5).
4. That this is probably not the most effective tax-saving plan (for example, it does not consider immediate bequest for assets equal in value to the unified credit) is not at issue here.
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