Consequences of Modification of a QTIP Trust Settlement

Consequences of Modification of a QTIP Trust Settlement:
One Scenario in ‘The Tale of Moné Baggs Smith’

A “QTIP” trust is a “Qualified Terminable Interest Property” trust. It is often used by spouses in a second or subsequent marriage where at least one party has children from a previous marriage. The QTIP trust allows the decedent spouse to provide for the surviving spouse, while ultimately leaving the assets remaining at the subsequent death of the surviving spouse to the deceased spouse’s children. The QTIP trust does not eliminate estate taxes; it postpones them until the death of the second spouse.

In most cases, the QTIP trust is a very effective vehicle for this scenario. Sometimes, however, it does not work as intended. What can the family do then?

For an example of how a QTIP trust works—and a potential pitfall—let’s take a look at “The Tale of Moné Baggs Smith.”

In 2012, at the age of 89, the Texas oil tycoon married Vanna Nicole, a sexy 26-year-old 63 years his junior. Shortly after the marriage, however, Moné died. Vanna became the beneficiary of a $45 million QTIP Trust established by Moné. The QTIP pays Vanna all income for life, with a remainder to Moné’s children.

There’s just one problem: Moné’s children are 30 years older than Vanna, and Vanna is likely to outlive them.

Understandably, disputes arise immediately between Vanna and Moné’s children who were not happy with the situation, so the trustee engages an attorney to terminate the trust under the Florida Trust Code, using a non-judicial modification. Fortunately, all the parties agreed to the modification because the Code requires unanimous consent of all qualified beneficiaries.

Vanna, who has no assets of her own and has never made any taxable gifts, receives a distribution equal to the value of her life income interest based on the rates set by the Internal Revenue Service and her current age (approximately 65% of the value of the assets in the QTIP Trust in our scenario). Moné’s children receive the remainder of the assets in the QTIP trust (approximately 35%).

Moné used all his available tax exemption during his lifetime; therefore, none was portable to Vanna. In this scenario, what are the tax consequences of the termination of the QTIP trust?

Gift Taxes

Vanna receives $29,152,350 for her life income interest. She is deemed to have made a net gift of the remainder interest in the QTIP trust to Moné’s children (i.e., the amount of the gift is net of the gift tax paid out of the assets distributed to Moné’s children).  Moné’s children receive $12,845,464 after the $3,002,186 gift tax is paid.

Estate Taxes

Vanna loses her estate tax exemption to offset taxes at her death. If Vanna dies within three years of the termination, Section 2035(b) will cause the $3,002,186 of gift taxes to be included in Vanna’s gross estate for estate tax purposes. (It may be wise to consider an indemnity agreement from the remainder beneficiaries or life insurance to cover the risk.)

Income Taxes

Vanna is treated as having received the value of the life interest in exchange for the sale of her entire interest in the marital trust. She has zero income tax basis in her interest in the marital trust; therefore, the entire amount received is gain. The gain is treated as an amount realized from the sale of a capital asset. The capital gain would be considered long-term because the termination was more than one year after Moné’s death. Vanna’s income tax basis in the assets she receives on the termination of the QTIP Trust is equal to fair market value. The QTIP trust does not realize any gain unless appreciated assets are distributed to Vanna.

Any capital gain recognized by the Marital Trust would be paid from the remainder interest, thereby reducing the payout to Moné’s children. The children take a carryover basis in the assets they receive.

This is just one of many scenarios in which the parties could face tax consequences as a result of modification of a QTIP trust. When considering such a modification, it is important to consider all the options and consequences.

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