Property passing by bequest outright to a surviving spouse qualifies for the unlimited marital deduction. Property placed in trust for the surviving spouse may, depending upon the trust language, also qualify for the marital deduction. However, Code Sec. 2056(b) provides that a bequest to a surviving spouse will not qualify for the deduction where the interest passing to the surviving spouse will “terminate or fail.” Terminable interests are generally those which enable a person other than the surviving spouse to possess or enjoy any part of the property after a lapse of time or the occurrence of an event, such as the surviving spouse’s remarriage.
Two important exceptions to the terminable interest rule exist, and both require the use of a trust. The first is the “power of appointment” exception, found in Code Sec. 2056(b)(5). To qualify for this exception, the trust must provide that the surviving spouse will be entitled to all trust income, paid at least annually. The trustee must not have the power to accumulate income, even if creditors are seeking to reach the spouse’s interest in the trust. The trust must also grant the surviving spouse a general power of appointment, exercisable either during lifetime or at death, without conditions or limitations. The term “during lifetime or at death” is in the disjunctive: it is enough that the spouse have either an inter vivos or a testamentary power. If the spouse is given a power to invade principal during the spouse’s lifetime, that power must be broad and must not be limited by an ascertainable standard. The regs also provide that the power to invade principal must not require the consent of another trustee.
Although an outright bequest to a surviving spouse also produces an unlimited marital deduction, the use of a marital deduction trust confers upon an independent professional trustee the power to manage trust assets without limiting the surviving spouse’s power to consume. However, like an outright bequest, bequests to a marital deduction trust bestow upon the surviving spouse a testamentary power to divert trust assets away from the class of persons who would likely be the donor’s intended recipients. This disadvantage is mitigated by the second exception to the terminable interest rule: the QTIP trust.
Like the power of appointment trust, property contributed to a QTIP trust will be deducted from the gross estate of the donor spouse, and the remainder, if any, will be included in the estate of the surviving spouse, who must also be given a lifetime right to all trust income. The QTIP trust is also distinguishable in that: (a) the power to invade corpus may be subject to the trustee’s discretion but must be limited by an ascertainable standard; (b) no one, including the surviving spouse, may be given a lifetime power to appoint trust property to anyone but the surviving spouse; and (c) QTIP treatment must be elected by the executor of the decedent’s estate. The Code provides that estate taxes imposed on a QTIP trust at the death of the surviving spouse may be collected by the executor of the estate of that spouse unless the donor’s Will clearly indicates otherwise.
A unique element of post-mortem estate planning is possible with the power of appointment trust, since the surviving spouse can make a testamentary disposition to those of the donor’s heirs who are most in need of the trust corpus at his or her death. On the other hand, a QTIP trust may be preferable in a second marriage situation where the donor wishes to provide for children of a prior marriage. The QTIP trust also permits the use of a “reverse QTIP election” under Sec. 2652(a)(3), which permits a donor making an inter vivos gift to a QTIP trust to elect QTIP treatment with respect to the transfer for gift tax purposes, but not for generation skipping transfer tax (GSTT) purposes. Thus, the election would enable the donor to make full use of the $1 million GSTT exemption, while still qualifying the transfer for the unlimited marital gift tax deduction.
The primary tax objective in funding a marital deduction trust is typically to reduce estate tax liability to zero for the first spouse to die, thereby enabling trust assets to appreciate without the imposition of transfer tax until the death of the second spouse. Despite this objective, there are still circumstances where the unlimited marital deduction should not be maximized: first, the steep progressivity in the estate tax rates could result in a lower total estate tax if some tax is paid at the first death (especially if the combined estates of both spouses exceeds $1,250,000); second, assets which appreciate between the first and second deaths will be taxed at higher rates if the marital deduction is claimed; and third, the estate tax credit for prior transfers will be lost if the marital deduction is claimed.
Code Sec. 2013 provides that an estate is entitled to a credit for part of the estate tax paid by the transferor’s estate, provided the second death occurs within 10 years of the first, and the transferred property was included in the transferor’s taxable estate. The credit begins at 100 percent if the decedents die within 2 years of each other, and decreases by 20 percent for each 2-year period thereafter. As a general rule, foregoing a QTIP election may result in overall tax savings if second spouse dies within 5 years of the first. Since the decision to elect QTIP treatment need be made no earlier than the filing of the estate tax return, it may be prudent to delay filing the Form 706. Since the IRS now recognizes the validity of contingent QTIP bequests (i.e., a bequest made conditional on the executor electing QTIP treatment), granting the surviving spouse the right to disclaim a QTIP bequest should not invalidate the QTIP election if the bequest is not disclaimed.
Often, a Will contains both a credit shelter and a marital deduction trust. A bequest of assets to the various trusts may be governed by a pecuniary formula whose objective is to produce the lowest federal estate tax. Under the most common pecuniary formula, the bequest to the marital deduction trust is equal to a pecuniary amount, and the residue of the estate passes to the credit shelter trust. The use of this formula is relatively simple, since once the value of the estate is determined, the marital deduction trust can be funded. Since the marital trust is being funded with a sum certain, appreciation in estate assets before funding will shift to the credit shelter trust. This will effectively leverage the unified credit. If the assets used to fund the marital bequest increase (decrease) in value before funding, the estate will be required to report taxable gain (loss). Although use of the pecuniary marital formula does require final estate tax values of assets, partial funding within reasonable limits can be undertaken before those values are determined.
The “reverse” pecuniary formula funds the credit shelter trust first, with the residue passing to the marital deduction trust. Since this trust is being funded with a pecuniary amount, the marital deduction trust will benefit from appreciation in estate assets before funding. The principal advantage of using a pecuniary bequest to a credit shelter trust is that funding can occur rapidly, since the amount needed to fund the credit shelter trust is readily determinable and does not depend on alternate valuation elections made under Code Sec. 2032, or on disclaimers from the marital deduction trust.
The impact of the qualified family owned business (QFOB) deduction, as amended in 1998, should also be considered when funding marital deduction and credit shelter trusts. Although the estate will benefit from claiming the deduction, assets must still be allocated to either trust. If a pecuniary bequest is made to the credit shelter trust based on the maximum exclusion amount, the marital deduction trust — funded with the residue which includes assets comprising the QFOB deduction — may be overfunded and the credit shelter trust underfunded, which could result in disastrous estate tax consequences. To avoid this problem, the Will might instead direct that a pecuniary bequest be made to the marital deduction trust. Presumably, no underfunding of the credit shelter trust would occur, since the assets for which the QFOB election were made would fund the credit shelter trust.
For larger estates, the impact of the GSTT should also be considered when planning for the marital deduction. In most cases, the GSTT exemption, currently $1 million, can be allocated to the credit shelter trust, which typically provides for benefits to skip generations. However, since the applicable credit amount will not reach $1 million until 2002, the GSTT exemption may also offset a bequest made to a QTIP trust. Code Sec. 2632(c) permits a “reverse” QTIP election to treat the first spouse to die as having made the transfer for GSTT purposes. Since the election is an “all or nothing” proposition, it may be necessary to create two marital deduction trusts, one of which can absorb the entire GSTT exemption. Note that a reverse election cannot be used with a power of appointment marital deduction trust, only a QTIP trust.