A QTIP trust is a special type of trust normally used in Estate Planning. The acronym stands for Qualified Terminal Interest Property Trust. This type of trust is normally used to take advantage of the marital deduction for gift tax and estate tax planning. Before we talk about how it is used, it will be helpful to talk about these marital deductions.
Marital Deductions for Estate Tax and Gift Tax
The first thing that everyone should realize about these concepts is that they are not true deductions. Normally when we see the word “deduction” as it pertains to taxes, we think of an amount that we can use to permanently reduce our tax liability in a current year. These two deductions do not permanently reduce your tax liability. These deductions just delay the tax liability till a later time.
Gift taxes are taxes imposed upon a gift that we give to someone else. So anytime that you give something of value to someone else, there could be a chance that the IRS is owed some money. As of the writing of this article in 2017, the gift tax exclusion is $14,000.00 per person or $28,000.00 per married couple. What this means is that you can give away upto $14,000.00 to any person without having to file a Gift Tax Return. If both you and your spouse give gifts to the same person then you can give them up to $28,000.00 in value without needing to file this return.
Estate Taxes are also known as the Death Tax. After you pass away, there is a chance that you will have to pay taxes out of the wealth that you leave behind. However, the total value of your Estate has to reach certain value thresholds before you have any liability. In 2017, your Estate upon death has to be valued at more than $5.49 million before you owe any Estate Tax to the Federal Government. Every dollar above that amount will likely be taxed. Minnesota also has a Death Tax for the State.
Minnesota’s Estate Tax threshold rises every year until it reaches $2 million. In 2017, the threshold is $1.8 million and this will increase to $2 million in 2018. If you have an estate valued at more than these amounts when you die then you will potentially owe tax to Minnesota. Currently, the Federal Estate Tax Rate is 40%. You would pay 40 percent on every dollar above the $5.49 million threshold. In Minnesota, the Estate Tax rate is between 10%-16% depending on other facts about the estate.
As you can see, most Americans will never be liable for Federal Estate Tax. However, it isn’t that difficult to reach the limit for Minnesota. If your home is valued at around $300,000 and you have another $700,000 in retirement assets in IRAs, Pensions, and 401ks, then all it takes is a $1 million dollar life insurance policy and now you are at the threshold for Minnesota Estate Tax.
Now how do these deductions work? Anything that you give to your spouse during your life or that your spouse inherits upon your death are not included when you calculate whether or not your estate totals $2 million or $5.49 million. So, many people like to give their spouse a significant part of their estate either during their lifetime or at death. This will delay taxes on these items until after the second spouse dies. The second spouse may have used a significant amount of those assets during their lifetime to live. They might also have given some of them away in other ways that make them no longer counted towards the threshold.
When the second spouse dies, we then tally up their estate. It includes their property and the property that their spouse has given to them upon death or in life. It is only then that the taxes become due. If the second spouse’s estate is above the thresholds then taxes will be paid. If not then they won’t. You could have plenty of estates where the first spouse dies the value is so high that there might have been taxes. However, by the time the second dies, the value might have lowered enough so that taxes are not paid.
As the name of the trust might hint, this type of a trust involves what are known as terminable interests. What are terminable interests? A terminable interest is an interest that has an expiration date. That date might be a set amount of time, the occurrence of a future event (such as death), or the failure of some event to occur (such as the exercise of an option). What is not intuitive is that this trust is used for the marital tax deductions, but terminable interests are not eligible for this deduction. I will provide you with two examples below.
Donald and Sandy live in rural Minnesota. Donald is a farmer and the family farm has been in his family for generations. When Donald dies, he leaves the farm to his son Joseph, but he wants his wife to still be taken care of for the rest of her life. So, he leaves a Life Estate in the farm and the farm house to Sandy. Sandy is then able to have a place to live and she can earn money by renting out the farm land. Sandy has a terminable interest in the farm because this interest ends when she dies. Donald can not use the value of this life estate for the marital deduction from Estate Tax.
Let’s take the above scenario, but let’s say that Donald left the farm to Sandy so long as it was only used to grow sugar beets. Sandy ever plants, or allows a tenant to plant, sweet corn then the farm will immediately go to the son Joseph. This is an example of the occurrence or non occurrence of an event. We don’t get to wait and see when Sandy dies either. The mere fact that it is possible for Sandy to lose the farm makes this a terminable interest.
Qualified Terminable Interests
Even though most terminable interests do not qualify for the Marital Deduction, qualified terminable interests do qualify. There are certain legal criteria that terminable interests have to satisfy to become qualified. Even if the interest is eligible to become a qualified terminal interest, the personal representative (or the spouse that made the gift during life) for the deceased spouse’s estate must make an election to take the marital deduction for a terminable interest.
Lifetime Income Interests
The qualifying income interests for life is the first type of qualified terminable interest. This most often comes into play when the dying spouse gives the income from an asset to the surviving spouse during life and then the asset goes to someone else upon their death. Let’s say Donald left Sandy the income from the farm, but not the farm itself. That the income was only for while Sandy was alive. If the farm was in a QTIP then this could qualify for the marital deduction if it meets these requirements:
- Sandy must have the right to all income from the property for as long as she lives
- It has to be paid out at least annually, but it could be quarterly or monthly. It just can’t be more than annually.
- No one can have the power to appoint the property to anyone other than the spouse. (not even Sandy)
- The Personal Representative of the dead spouse’s estate must irrevocably elect to take the marital deduction for the property on the Federal Estate Tax Return (or gift tax) and Minnesota Estate Tax Return
Income from Charitable Remainder Trusts
A Charitable Remainder Trust is another Estate Planning device. It is not the subject of this writing, but you can email us at the form at the bottom and we will answer those questions. Let’s say that when Donald dies he leaves the farm in a trust that has as its beneficiaries Sandy and a Charity. If these are the only beneficiaries then the farm could be a qualified terminable interests. Sandy must only have the right to the income from the farm. In this case, Sandy’s right to the benefit doesn’t have to be life long. The income could go for say ten years or even 20, but then after that time the charity gets it all.
Tax Consequences and the QTIP
Congress decided to allow the marital deduction because when the second spouse dies then the IRS gets its chance to collect taxes. It is a device to allow for the surviving spouse to still enjoy the benefit of most or all of the property of the deceased spouse during their lifetime. The Death Tax is a transfer tax just like the Estate Tax, but we like to treat the married couple as one unit. This unit doesn’t die until both are deceased. Many couples like to plan for termination of the other spouses interests at the death of the first. This normally is not allowed, but for qualified terminable interests, the QTIP gets to violate that rule.
A Brief Word on QTIP Use
QTIPs often address concerns regarding keeping assets in the family. If the surviving spouse remarries then they can’t leave the asset to anyone else upon their death. They also won’t be able to, in most instances, sell the property during their lifetime. You are able to take care of your spouse while also placing safeguards in place to make sure that the person you ultimately want to inherit the property gets it.
If you have any questions or want to know more about QTIPs or Estate Planning then fill out the form below:
Any U.S. federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this page.