QTIP Trust

A QTIP trust is a trust holding property that qualifies for the federal estate tax marital deduction under Internal Revenue Code section 2056(b)(7): the surviving spouse holds a qualifying income interest for life, and the executor of the first spouse's estate makes an election on the estate tax return. Without the election the property is a terminable interest and no deduction is allowed; with it, the property is treated as passing to the surviving spouse and no estate tax is due at the first death.

QTIP is an acronym for qualified terminable interest property, which is the statute's own term. Strictly, section 2056(b)(7) describes property rather than a trust, and property can qualify without one. In practice the property is nearly always held in trust, which is why Treasury's own regulations and the Form 706 instructions both speak of a QTIP trust.

What the statute requires, in its own words. Section 2056(b)(7)(B)(i) defines qualified terminable interest property as property that passes from the decedent, in which the surviving spouse has a qualifying income interest for life, and to which the election applies. Clause (ii) then defines the income interest: the surviving spouse must be "entitled to all the income from the property, payable annually or at more frequent intervals," and no person may have a power to appoint any part of the property to anyone other than the spouse. That second condition has a carve-out that makes the whole structure work, and it sits in the sentence immediately after: it "shall not apply to a power exercisable only at or after the death of the surviving spouse." So a remainder fixed for the children is fine; a trustee's power to hand principal to them while the spouse is alive is not.

This is the answer to why a trust needs section 2056(b)(7) at all. Left to the general rule, an income interest for the spouse with a remainder to someone else is exactly the terminable interest section 2056(b)(1) disallows.

The election is the whole mechanism, and it is one-way. Section 2056(b)(7)(B)(v) says the election "shall be made by the executor on the return of tax imposed by section 2001. Such an election, once made, shall be irrevocable." Two practical consequences follow. First, the deduction depends on somebody filing a return and ticking a box, which is a different kind of risk from a deduction that applies automatically. Second, the election can be partial: clause (iv) provides that "a specific portion of property shall be treated as separate property," so an executor can elect on a fraction of a trust and leave the rest to be sheltered by the deceased spouse's own exclusion. That partial election is one of the main post-death planning levers a family still has after a first death.

The bill arrives at the second death, and it does not fall where people expect. Section 2044 includes in the surviving spouse's gross estate the value of any property in which the spouse had a qualifying income interest for life and for which the deduction was previously allowed, and section 2044(c) treats it as passing from that spouse. So the trust's full value at the second death, growth included, is taxed in the estate of a person who never owned it and whose own children may receive none of it. Congress anticipated the unfairness: section 2207A(a)(1) entitles the surviving spouse's estate to recover from the people receiving the property the difference between the tax actually paid and the tax that would have been payable without it. Section 2207A(a)(2) lets the surviving spouse waive that recovery by saying so specifically in a will or revocable trust, and a waiver made carelessly shifts a large tax from the first spouse's children onto the survivor's own.

Two edges worth knowing. Section 2519 provides that any disposition of all or part of a qualifying income interest is treated as a transfer of all the other interests in the property. A surviving spouse who gives away or sells the income interest therefore makes a taxable gift of the entire remainder, not of the modest interest actually transferred, and section 2207A(b) gives a matching right of recovery for the gift tax. Separately, because the property is in the surviving spouse's gross estate, section 1014(b)(10) gives it a new basis at that second death, so the remainder beneficiaries inherit it revalued rather than carrying the first spouse's basis forward.

The sequence, and then the arithmetic at the second death, which is where the surprises are.

1. The first spouse's document creates the trust and gives the surviving spouse all the income for life, payable at least annually, with the remainder fixed for named beneficiaries.

2. No one may reach the principal for anyone else while the spouse lives. A power to appoint principal away from the spouse during her lifetime disqualifies the property; a power taking effect at or after her death does not.

3. The executor elects on the estate tax return, in whole or on a specific portion. The election becomes irrevocable when the filing deadline, including extensions actually granted, passes.

4. The marital deduction applies, so no federal estate tax is due on the elected property at the first death.

5. At the second death the property is in the surviving spouse's gross estate under section 2044, at its value then, and the remainder beneficiaries take it with a new basis under section 1014(b)(10).

A hypothetical, with the recovery right included because it is the part people miss. Bernard dies leaving $3,000,000 to a QTIP trust for his second wife, Ingrid. She receives all the income for life; his two children from his first marriage take the remainder. His executor makes the election, and no estate tax is due at his death.

Ingrid dies fourteen years later. The trust is then worth $4,200,000, and that full amount is included in her gross estate under section 2044. Assume her own estate is already large enough that every additional dollar falls in the top federal bracket of 40 percent. The trust therefore adds $1,680,000 of estate tax to her estate's bill.

Ingrid's own children are not the ones who receive that $4,200,000. Under section 2207A(a)(1), her estate is entitled to recover the $1,680,000 from Bernard's children, who do. If Ingrid's will had contained a clause waiving the right of recovery, her estate would have absorbed the whole $1,680,000 and her children would have inherited that much less, while Bernard's children received the trust intact.

A variation shows the other trap. Suppose that at age 78 Ingrid had assigned her income interest to Bernard's children to simplify matters. Section 2519 would treat her as transferring every interest in the property other than the income interest, so she would have made a taxable gift of the entire remainder value, not of the income stream she thought she was giving away.

Pros

• The first spouse to die controls who ultimately receives the property, which is the reason the provision was enacted and the reason blended families rely on it.
• No federal estate tax is due at the first death, because the elected property qualifies for the unlimited marital deduction.
• The surviving spouse's income is mandatory rather than discretionary, so a trustee cannot reduce it.
• The election is flexible after the fact: an executor can elect on a specific portion, using the deceased spouse's own exclusion on the rest, once the actual numbers at the first death are known.
• Because the property is in the surviving spouse's gross estate, it is revalued for income tax at the second death under section 1014(b)(10).

Cons

• The deduction depends entirely on an election that a person has to remember to make, on a return that has to be filed, and it cannot be undone once the deadline passes.
• All income must be paid out at least annually, which can force distributions a family would rather not make and limits any accumulation strategy.
• The property is taxed in the estate of a surviving spouse who never owned it, and the recovery right in section 2207A can be waived by a clause the survivor's own beneficiaries may not know about.
• Trustee, accounting and fiduciary income tax costs continue for the whole of the surviving spouse's life.
• Disposing of the income interest triggers a deemed gift of the entire remainder under section 2519, a result out of all proportion to what the surviving spouse usually thinks is being given away.