The Practical Essence of What is a QTIP Trust (estate tax planning).

The term QTIP comes from Section 2056(b)(7) of the Internal Revenue Code (the federal tax laws) and is short for “qualified terminable interest property”.    This provision was part of comprehensive tax legislation in 1981.  The QTIP trust provides the greatest level of flexibility, including many post-death income and estate tax planning options.  [There is also a QTIP lifetime gift provision under Section 2523(f) of the Code that I do not cover  in this post.}

This post is limited only to the practical essence of what is a QTIP trust in the estate tax context.

In short a QTIP trust deals with the concept of delaying estate tax for a married couple until the death of the surviving spouse, regardless of the size of the first-to-die-spouse’s estate.   In other words, the first spouse can have, for example, $100 million of assets and no estate tax is payable until the surviving spouse dies, but only under the following conditions:

The first spouse’s property must either (i) pass outright to the surviving spouse or (ii) in trust for the sole benefit of the surviving spouse for her lifetime.

Prior to the 1981 enactment of the QTIP provisions as to the above item (ii) trust option, the only allowable trust for a surviving spouse was a trust that essentially had to give complete control of the trust property to the surviving spouse.  Under this complete-control circumstance the surviving spouse — under the terms of the trust — could end up redirecting the trust property to a new spouse or to her own children from another marriage, etc.

In other words, the first-to-die-spouse had to give over control of the $100 million to the surviving spouse in order to get the benefit of delaying estate tax until the surviving spouse’s death.  This created problems with second marriages, marriages with children form a prior marriage, and so forth.  The 1981 QTIP legislation gave back control to the first spouse, as follows.

Here is the essence of the QTIP.   In the above example, with a QTIP trust the first spouse still gets the benefit of delaying estate tax on the $100 million by having the property pass into a QTIP trust for the sole benefit of the surviving spouse for her lifetime.  But, here is the additional kicker.

The QTIP trust provisions enable the first spouse — under the written terms of the trust document — to limit the surviving spouse’s control over the QTIP trust so that she cannot redirect the trust property to anyone else, such as a new spouse, other children, the  yard man, etc.   As written by the first-to-die-spouse, for example, the QTIP trust can mandate that the property passes only to the first spouse’s children when the surviving spouse dies.

Furthermore, the tax law for QTIPs requires — as a tradeoff for the above estate tax deferral — that the QTIP trust has to give the surviving spouse all income each year from the trust assets. This is typically only the ordinary income from the assets, such as dividends, interest, etc.   In most cases this minimum payout does not include capital gains.

However, the first spouse is not limited in designing the written terms of the QTIP trust to giving the surviving spouse only the ordinary income.   The first spouse may write the QTIP trust provisions so that they are much more liberal, as desired for the design of the trust.

Finally, the QTIP trust law mandates that during the surviving spouse’s lifetime no distributions of any nature from the QTIP trust are allowable to any other persons other than the surviving spouse.

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