What You Should Know About Lifetime QTIP Trusts
1. What is a Lifetime QTIP Trust?
A Lifetime QTIP Trust is an irrevocable trust created by one spouse for the benefit of the other spouse. The Lifetime QTIP Trust is often used to equalize the assets of each spouse, so that they can take advantage of both of their applicable estate tax exemptions no matter who dies first. The Lifetime QTIP Trust is especially useful when a spouse has children from a prior marriage. For example, Husband marries Wife, both of whom have children from a prior marriage. Husband transfers a major asset into a Lifetime QTIP Trust for benefit of Wife. The trust document is written so that after Husband and Wife have died, the remaining trust property is distributed to Husband’s children, and not to Wife’s children.
A Lifetime QTIP Trust is preferable to an outright gift because the donor spouse would lose control of an outright gift in the event of divorce or the beneficiary spouse’s death. It is sometimes used in conjunction with a prenuptial agreement.
Lifetime QTIP Trust property also benefits from increased creditor protection. During the life of the beneficiary spouse, the trust property is protected from creditors of the beneficiary spouse (although income distributions are not). The trust is also protected from creditors of the donor spouse, if the trust was established without intent to hinder or delay existing creditors.
2. How does a Lifetime QTIP Trust work?
A Lifetime QTIP Trust is typically funded with investment assets. Business interests also make fine QTIP Trust assets, provided the business is realistically able to pay out income each year. This is because a QTIP Trust is required to pay out all trust income to the beneficiary spouse. If the trust cannot realistically pay this income, the IRS could break apart the plan.
The beneficiary spouse is the only permissible beneficiary during the spouse’s lifetime. In addition to the income interest, the beneficiary spouse may have discretionary rights to receive distributions of principal. However, this optional provision should not be included in the donor spouse is serving as trustee.
Upon the death of the beneficiary spouse, the trust property will be distributed pursuant to the trust document. If the donor spouse is still alive, the document might allocate the trust property back to the donor spouse. The property would typically be held in yet another irrevocable trust for the donor spouse’s lifetime. When the donor spouse dies, the trust property would then
be distributed to the named beneficiaries. However, the document might give the donor spouse a right to change the named beneficiaries (a “testamentary limited power of appointment”).
Likewise, if the donor spouse predeceases the beneficiary spouse, the trust property would be distributed to the named beneficiaries. But the document might give the beneficiary spouse a right to change the named beneficiaries, usually exercisable among a limited class of beneficiaries (the donor spouse’s descendants, for example).
3. May the donor spouse serve as trustee?
The donor spouse may serve as trustee in some cases, but a more cautious approach is to name an independent Trustee. The donor spouse should not serve as trustee if discretionary principal distributions are permitted.
4. What are the tax consequences?
The transfer of property into a Lifetime QTIP Trust is treated as a taxable gift, but it qualifies for an unlimited gift tax deduction. A gift tax return is still required, but no gift is actually reported. Property in the QTIP Trust is excluded from the donor spouse’s taxable estate, although it will be included in the beneficiary spouse’s taxable estate.
A Lifetime QTIP is usually drafted as a grantor trust, which means that any trust income is taxable to the donor spouse. This also qualifies a Lifetime QTIP Trust as an eligible S-Corporation shareholder.
If the beneficiary spouse dies first, and the property reverts to an irrevocable trust for benefit of the donor spouse, then the trust may continue to be treated as a grantor trust. This can “supercharge” the trust by permitting the grantor to effectively make tax-free gifts to the ultimate beneficiaries when paying tax on trust income.
5. What does QTIP mean?
The term QTIP stands for Qualified Terminable Interest Property. Generally, the tax code grants an unlimited exemption for gifts from one spouse to another, provided they are given outright and without restriction. Gifts to a QTIP trust also qualify for the unlimited exemption under the tax code even though the donor spouse is able to restrict the beneficiary spouse’s rights under the trust. The trustee must notify the IRS about the existence of the QTIP trust on a gift tax return (Form 709) and pay out all income to the beneficiary spouse at least annually.
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.
Thomas J. Bouman, Attorney
Bouman Law Firm
7650 E. Broadway Blvd. #108
Tucson, AZ 85710
(520) 546-3558
