Dec. 14, 2023
Blending families can be the hardest part of a second marriage. A family fortune only makes it more complicated.
Wealthy Americans can use trusts to save on taxes and take care of their spouse's needs after their death. But for taxpayers on their second marriages (or beyond), this can rankle their adult children who want their piece of the pie.
Thankfully there's a path to compromise.
Using a qualified terminable interest property trust, also known as a QTIP, married taxpayers can put their fortunes in trusts that pay distributions to their spouses. The appeal of a QTIP is that the beneficiary spouse receives income from assets within the trust — such as stock dividends or business profits — but the principal is untouched. When the beneficiary spouse dies, everything in the trust is transferred to new beneficiaries, typically the adult children of the spouse who funds the trust.
"For later marriages, I think some people might not be interested in just handing over assets," said Dan Griffith, the director of wealth strategy at Huntington Bank. "They really want to give the benefits, including income, which is not nothing. It's a real benefit while at the same time not giving unfettered access."
QTIPs can provide peace of mind to clients worried about what will happen to their assets if their spouse outlives them, such as gifting them to someone they remarry, Griffith said.
"I could still have the knowledge and comfort that those dollars would end up with my kids from my first marriage," he said.
Discussing QTIPs, Griffith said, requires a delicate touch. Other types of trusts are more favorable to beneficiary spouses, such as spousal lifetime access trusts, which allow some control over the assets.
"It really is just one of those things that you've got to feel the client out and say: 'All right, what's the priority going to be? How much do they trust each other?'" he said.
The 2 main types of QTIPs
QTIPs come in two flavors.
A testamentary QTIP is triggered by the death of the spouse who funds the trust, otherwise known as the grantor spouse. The death of the grantor spouse doesn't trigger an estate tax, regardless of the size of the estate. The estate tax comes due when the beneficiary spouse dies, even though they didn't control the assets in the trust.
Testamentary QTIPs are more common, as many people are reluctant to make estate plans and they die unexpectedly. The executor of their estate can elect whether to transfer property — and how much — to a QTIP and file for a marital estate tax deduction.
An inter-vivos QTIP is funded during the grantor's life. Forming an inter-vivos QTIP requires a client to part with a source of income before they die, and it can't be taken back.
How QTIPs work
Testamentary QTIPs can reduce your tax burden, but this isn't guaranteed. Any tax savings depend on how much the trust assets appreciate and how estate-tax exemptions change between the grantor spouse's death and the beneficiary spouse's death.
Thanks to the 2018 tax law, the federal exemption is a whopping $12.92 million per individual, though that's set to expire in two years. If it does and the exemption is lowered to its pre-2018 level of $5 million, adjusted for inflation, testamentary QTIPs may become more popular, Griffith said.
Inter-vivos QTIPs have a significant advantage as they allow a married couple to fully use their individual exemptions of $12.92 million, even if one spouse is significantly richer than the other.
Here's an example of how it can work, according to Griffith:
Consider a married couple, Jay and Chris. Jay has children from his prior marriage. He owns a business worth $18 million and has $1 million in a retirement account. Chris has a personal residence worth $500,000 and retirement assets of $500,000. Jay wants to provide for Chris but wants to ensure his company passes to his children.If the couple does not do any estate planning and Chris dies before Jay, Chris' assets pass to Jay. No estate tax is incurred as his assets are well within the exemption and it uses the unlimited marital exemption. However, when Jay passes, his estate will be on the hook for federal estate taxes on any assets in excess of the exemption. If the exemption of $12.92 million holds and the combined estate value stays flat at $20 million, this would incur $2.8 million in federal estate taxes. The tax burden would be larger if the exemption is lowered and the assets appreciate significantly by the time Jay dies.
If the same couple used an inter-vivos QTIP, they could use both exemptions:
Instead, Jay can form two trusts: one worth $12.92 million that uses his exemption and an inter-vivos QTIP worth $6.08 million for benefit of Chris. (The beneficiary of the first trust can be Chris but could also be Jay's children.) The assets in the first trust are not subject to estate tax when Jay passes, and he gets to use the current exemption even if he dies after the tax cuts expire. The assets in the QTIP are only taxed when Chris passes. If the value of the assets in the QTIP does not exceed whatever the exemption is at his time of death, Chris' estate would not incur any federal estate taxes. After Chris' death, Jay's children have inherited all of their father's business interests. The outcome is the same even if Chris dies before Jay.
There are nontax benefits. QTIPs ideally contain a spendthrift clause, which prevents heirs from using trust assets or their right to trust income as collateral. Depending on the jurisdiction, assets within the QTIP can be shielded from creditors' or divorcing spouses' claims.
The beneficiary spouse also has no control of the assets within the trust. A trustee appointed by the grantor spouse is responsible for managing the assets. This is especially beneficial for grantor spouses worried about a beneficiary spouse's spending habits or debts, or the possibility of their becoming incapacitated or scammed as they age.
There are some caveats
1. The beneficiary spouse must be a US citizen.
2. The beneficiary spouse must receive the trust's entire net income.
This is one of several compliance requirements. Another is that the beneficiary spouse must be paid at least once a year.
3. If the couple divorces, the beneficiary spouse may still be entitled to income from a QTIP.
Griffith said that whether QTIPs are defined as marital property varies state by state and that a judge may see a right to future income as a gift.
4. The property in the QTIP must produce income.
While there are no formal requirements for the types of assets in a QTIP, ideal ones include dividend-yielding stocks, rental properties, and business interests, Griffith said. Though QTIPs are irrevocable, meaning assets cannot be withdrawn, a beneficiary spouse can compel the trustee to sell a non-income-producing asset.
5. The beneficiary spouse is entitled to the income even if they remarry.
While the beneficiary spouse can't gift their right to income to their new spouse, remarriage doesn't change the conditions of the QTIP. Griffith said that while this may irk the children of the deceased grantor spouse, it's fair.
"The trust can't take away that right to income," he said. "They wouldn't have any benefit, and it would still be included in their estate, which is not equitable."
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