Question:  What is a Qualified Terminable Interest Property Trust?

Answer:  A QTIP trust is a type of irrevocable trust that can be used to give income and principal to a surviving spouse after the first spouse dies and then after the surviving spouse dies give the assets that remain in the trust to the beneficiaries selected by the first spouse to die.  Any irrevocable trust can be drafted to do the same thing.

Estate planning attorneys use a QTIP trust when both of the following facts exist:

  • The first spouse to die wants to leave assets to the surviving spouse that can be used only by the survivor during his or her life (aka a “life estate”).
  • The first spouse to die has an estate that is greater in value than the federal estate tax exemption amount ($5,250,000 for people who die after 2012).

A QTIP contains certain language required by the IRS so that the assets transferred to the QTIP will qualify for the federal estate tax marital deduction and not be included in the estate of the first spouse to die and taxed when the first spouse dies.  Without the special language necessary to qualify as at QTIP the assets transferred into the trust by the first spouse to die would not be eligible for the federal estate tax marital deduction in determining the federal estate tax due on the death of the first spouse.

I typically create a trust for a married couple that creates two or three trusts after the death of the first spouse.  These new trusts created after the death of the first spouse are frequently referred to as the A & B trusts or the A, B & C trusts.  Myself and many estate planning attorneys call the A trust the “survivor’s trust,” the B trust as the “family trust” and the C trust the “QTIP trust.”  Normally the B trust aka the family trust does not contain the language needed to make it a QTIP trust.

When a married person has children who are not the children of his or her spouse, it is very common that the person wants to provide for the surviving spouse during the spouse’s life if the married person is the first spouse to die, but then have the assets that remain in trust go to the children of the first spouse to die after the surviving spouse’s death.  Estate planning attorneys accomplish those objectives by creating a trust that has the A & B trust structure or the A, B & C trust structure.

The article you linked is written on the assumption that the only way to accomplish your goals is to create a QTIP trust if you die first.  Not true.  You an accomplish the same thing by adopting the A/B trust structure and having the B trust (family trust) written to provide for your wife while she is alive and then have the balance of the assets at her death be held in trust for your children.

You are probably wondering what is the difference between the B trust and the C trust (the QTIP)?  In your case the only difference is that the QTIP requires that all of the income be distributed at least annually to the surviving spouse.  The reason for this income distribution requirement is so that the assets transferred into the QTIP will qualify for the federal estate tax marital deduction given to assets transferred on death by one spouse to the surviving spouse.  The legal significance of the federal estate tax marital deduction is that it will allow Bill Gates to leave his $25 billion plus in assets to his wife Melinda and no federal estate taxes will be incurred as a result of that large transfer until Melinda dies.

Because the federal estate tax exemption amount is currently $5,250,0000, you do not need a trust that would create a QTIP unless your estate were to exceed $5,250,000.  It is only when you will be transferring more than $5,250,000 after your death that you need a QTIP trust to hold the excess over the exemption amount.  The trust you and your wife create doesn’t need to create the A, B & C trust structure.  As long as the total value of the estate of each spouse is less than $5,250,000 that spouse does not need for assets transferred to the B trust to qualify for the federal estate tax marital deduction.

Two examples will help to explain how the A & B trust structure and the A, B & C trust structure work in real life.

Example 1:  Homer and Marge Simpson have an estate of $2,000,000, all of which is community property.  They have three children plus Homer has a son with another woman.  Homer wants Marge to be able to use his assets while she is alive and on Marge’s death Homer wants his assets to go equally to his four kids.  They sign a trust that has the A & B trust structure.  Homer dies in 2013 when the federal estate tax exemption amount is $5,250,000 so there is no federal estate tax on Homer’s assets.

Marge, as trustee of their joint trust creates the Survivor’s Trust and the Family Trust.  She transfers $1,000,000 in assets to each trust.  The original trust ceases to exist and now Marge is the trustee of two trusts, the Survivor’s Trust and the Family Trust.  The Survivor’s Trust is revocable and Marge can do whatever she likes with her assets in the Survivor’s Trust.  The Family Trust, however, is irrevocable and cannot be changed.  Homer’s four kids will someday become the beneficiaries of what remains in the Family Trust at Marge’s death.

The Family Trust provides that the trustee has no obligation to pay any income or principal of the trust to Marge.  Marge, as trustee, has sole discretion as to how much and when to transfer assets to Marge or use the assets for Marge’s benefit.  Assets in the Survivor’s Trust have no asset protection because the trust is revocable.  Assets in the irrevocable Family Trust are asset protected from the creditors of the beneficiaries of the Family Trust.  Because the Survivor’s Trust lacks asset protection, Marge should spend money from the Survivor’s Trust first and if possible use the assets in the Family Trust as a rainy day fund.  However, if Marge needs income or principal because the assets in the Survivor’s Trust are not enough to support her Marge can use the assets of the Family Trust for her benefit.

The one potential fly in the ointment that could prevent Homer’s children from inheriting much, if any, assets in the Family Trust is that their inheritance is dependent on Marge not spending it all and/or not making bad investments that decrease the value of the assets held in the Family Trust.  The solution to this problem is to provide in the Family Trust that the trustee will not be Marge.  The choices for trustee of the Family Trust are: (i) the beneficiary of the trust, (ii) a trusted family member or friend or (iii) an institutional trustee that has decades of experience acting as trustee for trusts.  I recommend the institutional trustee for the following reasons:

  • They have professional money managers who know how to invest and grow assets.
  • They have a deep pocket and can be sued if they lose money.
  • Best choice for maximum asset protection for the heirs because no heir will ever be a trustee.

The only downside for having an institutional trustee is that they charge a fee for their trustee services.  A common fee is 1.25% of the assets under management each year up to $5,000,000.  This may seem like a lot, but it isn’t if you consider the institutional trustee probably will make more money each year than the surviving spouse and children would make and the fee structure gives the trustee an incentive to grow the assets.

Example 2:  Same facts as Example 1 except the Simpson’s total net worth is $12,000,000.  Their joint trust provides that on the first spouse’s death the survivor’s assets will go into the Survivor’s Trust, the Family Trust will be funded with the deceased spouse’s asset up to an amount equal to the federal estate tax exemption amount ($5,250,000 in 2013), and the excess over that amount will go into the QTIP Trust.

Marge creates three trusts, the Survivor’s Trust (revocable), the Family Trust (irrevocable) and the QTIP Trust (irrevocable).  Marge transfers $6,000,000 to the Survivor’s Trust, $5,250,000 to the Family Trust and $750,000 to the QTIP.  Both the Family Trust and the QTIP Trust provide that Marge is the current beneficiary and the four children are the beneficiaries after Marge dies.  The only difference between the Family Trust and the QTIP Trust is that distributions from the Family Trust are solely at the trustee’s discretion, but the trustee of the QTIP must distribute to Marge each year an amount that is not less than the income earned by the QTIP Trust during the year.

Note that the A, B & C trust structure allows the Simpson’s to avoid federal estate tax on an amount not less than the combined federal estate tax exemption amount of both spouses, which currently is $10,500,000.  The actual amount of federal estate taxes saved could be much higher than the exemption amount because the entire amount of assets in the Family Trust is not subject to federal estate tax when the second spouse dies.  For example, if Marge were to die twenty years after Homer and the value of the assets in the Family Trust had grow to $12,000,000 none of the $1,2000,000 would be subject to federal estate tax.

For a more detained discussion of federal estate tax law and the QTIP Trust read Qualified Terminable Interest Property Trust.